Companies worldwide, be it start-ups, SMEs, or multinational companies, constantly work to achieve clear goals defined by the management and the board of directors. The company's performance has to be measured for the management to understand the business numbers and closeness to the company’s goals. Additionally, for a listed company, the shareholders will need to be informed of its performance. This performance of a company is measured using specific parameters. A financial ratio is one such parameter to gauge performance.
What are Financial Ratios?
Financial ratios are a simple mathematical ratio that is obtained when one variable is divided by another. The variables will be financial parameters taken from the company’s books. Financial ratios are calculated using performance measuring financial tools such as balance sheets and income statements after required Internal audits and External audits. The calculation of financial ratios with data from the variables will enable the management and shareholders to understand how the company is doing internally and compare with competitors from the sector.
Types of Financial Ratios
There are different types of financial ratios based on the available financial tools, which will help measure a company’s success on various factors. Financial ratios are generally divided into categories based on profitability, solvency, liquidity and valuation. There are many financial ratios used to analyse the company’s numbers by the management and shareholders. The most common of the financial ratios that every company should know are:
Net Profit Margin
Net profit margin is a financial ratio based on the profitability scale. It is obtained by dividing the company's net income in a specified period by the total revenue obtained in the same period. The higher the profit margin, better the net profit margin, which indicates the company's good performance on the profitability front. It is always ideal for comparing the company’s current growth with the previous year or with competitors.
Net Profit Margin = Net Income/Revenue
The current ratio is a financial ratio based on the liquidity scale. It will help the company predict and understand the company's short-term liquidity based on the current assets and current liabilities. The higher current ratio indicates the good financial health of the company. It indicates the ability of the company to pay its short-term obligations.
Current Ratio= Current Assets/ Current Liabilities
The quick ratio is a financial ratio based again on the liquidity scale. It is famously known as the ‘Acid Test Ratio’. It measures the current short-term debts of the company with its liquid assets. The higher Quick ratio indicates the good financial health of the company.
Quick Ratio= [Current Assets- (Inventory + expenses) / Current Liabilities]
Debt to Equity Ratio
Debt to Equity Ratio is a financial ratio based on the solvency scale. It indicates the total proportion of the company’s equity and debt used to finance its current assets. The ratio is obtained by dividing the total debt with the shareholder’s equity. Companies and business analysts around the world use this ratio to analyse the company’s performance.
Debt to Equity Ratio= Total Liabilities of company/ Shareholders Equity
Price to Earnings Ratio
Price to Earnings Ratio is a financial ratio based on the Valuations scale. This ratio is one of the market’s favourite metric to acknowledge the data to decide a company’s valuations by the business analysts and traders. It indicates how much an investor needs to invest to earn a single dollar from the company.
Price to Earnings Ratio= Market Value per company share / Earnings per company share
There are other financial ratios like Operating margin, EBITDA margin, Return on Equity (ROE), return on Capital Employed (ROCE), Operating cash flow ratio, Inventory Turnover, Working Capital Turnover, Price to book ratio etc. which are also useful in gauging the performance of the business. However, companies must be knowledgeable in using these ratios to analyse the performance as benchmarks vary across various sectors. The ratios will provide a level ground for comparing the internally with its past performance or comparing with business competitors in the same sector.
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