What are financial ratios? Definition and meaning

Financial ratios, also known as accounting ratios, are used to measure a company’s financial situation or performance against other firms, the industry average, or its own past figures.

The majority of ratios can be calculated from data contained in the financial statements.

Commonly used in accounting, there are several standard ratios used to evaluate the overall financial condition of a company or other organization.

The calculations may be used by managers inside a firm, shareholders, or creditors. Financial analysts use financial ratios when comparing the strengths and weaknesses of several companies.

Financial Ratios‘Financial ratios’ refers to several different types of calculations that people make by using data contained within a company’s financial statement.

In some financial ratios, the market price of a company’s shares (if they are traded in a financial market) is used.

Financial ratios can be categorized according to their data source and the information they provide. Below are the five most-commonly used ratios:

– Asset turnover ratios: sometimes referred to as asset management ratios, asset utilization ratios, or efficiency ratios, they give us an idea of how efficiently a business is utilizing its assets. The two most commonly used asset turnover ratios are inventory turnover and receivables turnover.

– Dividend policy ratios: help us determine a firm’s prospects for future growth, as well as providing insight into its dividend policy. The two most commonly used ratios are the payout ratio and dividend yield.

– Financial leverage ratios: with these types of ratios we can get a better idea of a company’s long-term solvency. In contrast to liquidity ratios, which look at how a company copes with short-term assets and liabilities, financial leverage ratios measure how well the firm is using long-term debt. In this category, the most common ratios are debt ratio and debt-to-equity ratio. Debt ratio, for example, equals a company’s total debts divided by its total assets.

– Liquidity ratios: these ratios tell us about a company’s ability to meet its short-term financial obligations. Banks considering (or already) extending short-term credit are particularly interested in these data.

– Profitability ratios: these ratios give us an indication of how successful a company is at generating profits. The most common calculations are return on equity, return on assets and gross profit margin.

 

Financial ratios must have a reference point

NetMBA says that for a financial ratio to be meaningful you must have a reference point – it must be compared to historical values within the same company, or ratios of similar firms, i.e. they must be benchmarked against something else.

NetMBA adds:

“Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm’s situation.”

People usually use financial ratios to compare:

  • – one company against another (or others),
  • – one industry against another (or others),
  • – one point in time against another (or others) within the same company,
  • – a single company with the industry average.

When decimals and percentages are used

Ratios may be expressed as a decimal value (e.g. 0.10) or given as a percentage value (e.g. 10%). Some ratios, especially those that generally result in a figure of less than 1, are always quoted as percentages.

Ratios that result in a number higher than 1 are typically quoted as decimal numbers.

Using financial ratios to compare companies may be challenging, especially among private firms (not listed in stock exchanges) that use different accounting methods.

The majority of public companies (listed in stock exchanges) are legally required to use generally accepted accounting principles, and are thus easier to compare.