Financial Ratios: Meaning, Types, Examples, and Importance Explained

Financial Ratios are ratios used in business and accounting to measure the efficiency of a given company's performance. The purpose is to use the numbers created from financial statements to gain an understanding of the financial state of a given company. Financial Ratios are quite simple to figure out, but very effective in assisting people in making business decisions. All businesses, from the local grocery store to the largest corporation, make use of Financial Ratios to ensure they are tracking the way they would like.

A company, while setting up their financial reports, would need to understand the applications of Financial Ratios to see if the company is making a profit, effectively utilizing assets, or using debt correctly. In other words, Financial Ratios act as a report card on the performance of the given company. They inform investors, owners, and management whether the company is strong or weak.

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What are Financial Ratios?

Financial Ratios can be defined as the numerical value that is calculated on the basis of the relationship of two or more financial numbers provided in the financial statements. These ratios help in the study of financial numbers given in the company statements. Financial Ratios are useful in establishing relationships between the items. For example, relationships between income and expenses, liabilities and assets, etc. These ratios are applied by investors, banks, and managers in checking the company’s performance, profitability, and stability.

Types of Financial Ratios

Financial ratios can be classified into various types based on certain criteria or characteristics. These types are used to categorize ratios and help in analyzing different aspects of a company's financial health.

How to Calculate Key Financial Ratios

Financial Ratios are good indicators of a company's financial health. They are calculated using few formulas and basic information from the balance sheet and the income statement of a company. Let's go over some common ratios and their calculations:

1. Current Ratio

The Current Ratio = Current Assets ÷ Current Liabilities

It shows whether the company can pay short-term debts. A higher ratio means better liquidity.

2. Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders’ Equity

It measures how much a company relies on debt for financing. A lower ratio indicates less risk.

3. Net Profit Margin

Net Profit Margin = (Net Profit ÷ Net Sales) × 100

It shows how much profit a company makes from each sale. A higher margin means the company is more efficient.

4. Return on Assets (ROA)

ROA = (Net Income ÷ Total Assets) × 100

This tells how well a company uses its assets to earn profit.

5. Inventory Turnover Ratio

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

This shows how many times inventory is sold during a year.

6. Price-to-Earnings (P/E) Ratio

P/E Ratio = Market Price per Share ÷ Earnings per Share

This helps investors decide if the company’s stock is overvalued or undervalued.

Calculating these key ratios regularly gives businesses a better understanding of their operations. Each ratio plays a role in tracking growth, efficiency, and profitability.

Financial Ratios Examples

To understand Financial Ratios better, let’s see some simple examples.

Suppose Company A has current assets worth ₹2,00,000 and current liabilities of ₹1,00,000. Using the Current Ratio formula,

Current Ratio = ₹2,00,000 ÷ ₹1,00,000 = 2.0

This means the company has twice the assets compared to its short-term debts, which is a good sign of liquidity.

Now, if the company’s total debt is ₹5,00,000 and shareholders’ equity is ₹10,00,000, the Debt-to-Equity Ratio will be

Debt-to-Equity = ₹5,00,000 ÷ ₹10,00,000 = 0.5

This shows the company uses less debt and is financially stable.

If Company A earns ₹2,00,000 as net profit from ₹10,00,000 sales, the Net Profit Margin will be

Net Profit Margin = (₹2,00,000 ÷ ₹10,00,000) × 100 = 20%

This means the company keeps ₹0.20 as profit for every ₹1 sale, which is considered strong.

These examples of Financial Ratios show how useful they are for understanding a company’s performance quickly and easily.

Importance of Financial Ratios

Financial ratios are useful numbers that condense a lot of information into an easy-to-read format, and this eases the analysis process. The analysis of the financial ratios is significant to financial statement users since it allows for financial statements to be simplified and, as a result, economic decisions based on them are more meaningful. Ratios are used in financial statements to review a company’s profitability, productivity, liquidity, and solvency to ensure that a company is well-rounded and all-around. Major bullet points are listed below that will be highlighted on the importance of financial ratios:

• Helps to gauge the financial health and stability of a company.

• Make complex financial statements more understandable. 

• Measure profitability, liquidity, and efficiency of operations. 

• Enable benchmarking against peers and industry standards. 

• Facilitate forecasting, planning, and strategic decision-making. 

• Aid investors and lenders in risk and credit analysis.

• Help in identifying early warning signs of financial distress.

Limitations of Financial Ratios

Financial ratios are important tools used to evaluate and analyze the financial performance and position of a company. They offer insights into various aspects of a company’s financial health and aid in decision-making. However, like any analytical tool, financial ratios have several limitations that must be considered while using them. Here are the key limitations associated with financial ratios:

• Historical nature of financial ratios: Financial ratios are often based on historical financial statements and data, which may not accurately reflect the current or future situation of the company.

• Differences in accounting policies: Different companies may use different accounting methods and policies, which can impact the comparability of financial ratios.

• Ignoring qualitative factors: Financial ratios do not take into account qualitative factors such as the quality of management, market conditions, or industry trends, which can also affect a company's performance.

• Seasonal or cyclical fluctuations: If a company's operations are seasonal or cyclical in nature, financial ratios may provide a misleading picture if not analyzed over a long enough time period.

• Manipulation or “window dressing”: Financial data can be manipulated or presented in a way that temporarily improves the appearance of financial ratios, a practice known as “window dressing.”

• Comparability across industries: Financial ratios may not be directly comparable across different industries due to industry-specific factors and financial structures.

• Limited in scope: Ratios alone cannot provide a complete understanding of a company's financial situation and should be used in conjunction with other forms of financial analysis.