5 Important Financial Ratios

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There are different types of financial ratios which tells us information about company performance. In this blog, we will discuss 5 important types of financial ratios.

Financial Ratios

Financial Ratios –

  1. Profitability Ratio
  2. Liquidity Ratio
  3. Solvency Ratio
  4. Turnover Ratio
  5. Valuation Ratio
  1. Profitability Ratio – The profitability ratio is a very important type of ratio that tells us a company’s ability to generate income related to equity, assets, and capital employed.

ROE = Net Income / Equity

ROCE = Net Income / Capital Employed

  • Return on Asset or ROA This ratio shows us how efficiently a company is using its asset to generate income.

ROA = Net Income / Total Asset

2. Liquidity Ratio – This ratio shows us the company’s ability to repay its short-term obligations.

  • Current Ratio This ratio shows us the company’s ability to pay off its short-term liabilities with current assets.

Current Ratio = Current Asset / Current Liability

Quick Ratio = (Current Asset – Inventories) / Current Liabilities

  • Cash ratio This ratio shows us the company’s ability to pay off its short-term liabilities with cash and cash equivalents.

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

3. Solvency Ratio – This ratio shows us whether the company is solvent and can pay off the debt.

  • Debt Ratio This ratio shows us the company’s assets that are provided by the debt.

Debt Ratio = Total Liabilities / Total Assets

  • Debt to Equity Ratio This ratio shows us the leverage of the company. It shows the weight of total debt against its equity.

Debt to Equity Ratio = Total Debt / Equity

  • Interest Coverage Ratio This ratio shows us how many times the company’s profits are capable of covering its interest expense.

Interest Coverage Ratio = EBIT / Interest Expense

4. Turnover Ratio – This ratio shows us how well a company is utilizing its assets and resources to generate its revenue.

Asset Turnover Ratio = Net Sales / Average Total Assets

  • Inventory Turnover Ratio This ratio shows us how many times a company has sold and replaced inventory during a given time.

Inventory Turnover Ratio = Cost Of Goods Sold / Average Inventory

5. Valuation Ratio – This ratio shows us the relationship between the market value of a company or its equity and some fundamental financial metrics.

  • Earning Per ShareThis ratio shows us the amount of net income earned by each outstanding share.

Earning Per Share = Net Earnings / Total Outstanding Shares

  • Price To Earning This ratio shows us the relationship between a company’s share price to its earnings per share.

Price To Earnings = Share Price / Earnings Per Share

  • Price To Sales – This ratio shows us how much investors are willing to pay per dollar of a sale for a stock.

Price To Sales = Share Price / Sales Per Share

This financial ratio helps us to understand how profitable the company is, how the company is managing its liquidity, how the company is using its debts to generate earnings, how efficiently a company is using its assets, and what is the valuation of the company, is overvalued or undervalued. By analyzing these financial ratios we can understand how management is doing. Financial Ratios are easy to understand once you understand the logic behind the ratios. Once we understand the equation between the numerator and denominator of the formula then we can easily conclude the analysis of companies using financial ratios which will help us from an investment perspective to decide whether to invest or not.

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