Financial Ratios :An Indepth Understanding - Types, uses, formula

1) Liquidity Ratios:

Liquidity ratios measure a company's capacity to meet its short-term commitments. These include:

a) Current Ratio:

Formula: Current Assets / Current Liabilities
Significance: A higher ratio denotes better liquidity. A ratio below one indicates possible cash flow problems.

b) Quick Ratio (Acid-Test Ratio):

The formula is (Current Assets - Inventory) / Current Liabilities.
Significance: By assessing liquidity separately from inventory, it offers a more exacting indicator of financial health.

c) Cash Ratio:

Formula: Cash & Cash Equivalents / Current Liabilities
Significance: This ratio only considers the most liquid assets that can be used to settle short-term debts.

2. Profitability Ratios:

Profitability ratios help one to determine whether a company can make a profit in respect to income, assets, or equity.

a) Gross Profit Margin:

Formula: (Revenue - Cost of Goods Sold) / Revenue × 100
Significance: A bigger margin suggests good manufacturing and pricing strategies.

b) Operating Profit Margin:

Formula: Operating Profit / Revenue × 100
Significance: It reveals how effectively taxes and interest subtracted operations run.

c)Net Profit Margin:

Formula: Net Profit / Revenue × 100
Significance: A good gauge of the percentage of income turned to net profit.

d) Return on Assets (ROA):

Formula: Net Income / Total Assets × 100
Significance: A better ROA suggests efficient use of assets.

e) Return on Equity (ROE):

Formula: Net Income / Shareholder’s Equity × 100
Significance: compares profitability in respect to shareholder investments.

3. Efficiency Ratios:

Efficiency ratios assess a company's use of resources to generate income, so determining its degree of resourcefulness.

a) Asset Turnover Ratio:

Formula: Revenue / Average Total Assets
Significance: A higher ratio shows efficient asset utilization.

b) Inventory Turnover Ratio:

Formula: Cost of Goods Sold / Average Inventory × 100
Higher turnover rate indicates effective inventory control, hence the cost of goods sold / average inventory formula significance is higher.

c) Accounts Receivable Turnover Ratio:

Formula: Net Credit Sales / Average Accounts Receivable
Significance: Indices a company's debt collecting effectiveness.

4. Leverage Ratios—Solvency Ratios:

Long-term financial stability and debt capacity of a company are determined by solvency ratios.

a) Debt-to-Equity Ratio:

Formula: Total Debt / Shareholder’s Equity
Significance: Dependency on debt causes more financial risk indicated by a higher ratio.

b) Interest Coverage Ratio:

Formula: Earnings Before Interest & Taxes (EBIT) / Interest Expense
Significance A larger ratio implies improved capacity to pay interest.

c) Debt Ratio:

Formula: Total Liabilities / Total Assets
Significance: shows the debt-financed asset percentage.

a) Debt-to-Equity Ratio:

Formula: Total Debt / Shareholder’s Equity
Significance: Dependency on debt causes more financial risk indicated by a higher ratio.

a) Debt-to-Equity Ratio:

Formula: Total Debt / Shareholder’s Equity
Significance: Dependency on debt causes more financial risk indicated by a higher ratio.

5. Market Valuation Ratios:

Ratios of market value enable investors to assess a company's stock price in relation to earnings and other financial information.

a) Price-to-Earnings (P/E) Ratio:

Formula: Market Price Per Share / Earnings Per Share (EPS)
Significance: Overvaluation may be indicated by a high P/E ratio, whereas undervaluation may be suggested by a low P/E ratio.

b) Earnings Per Share (EPS)/strong>:

Formula: Net Income / Total Shares Outstanding
Net income divided by the total number of outstanding shares is a significant measure of a company's profitability per share.

c) Price-to-Book (P/B) Ratio:

Formula: Market Price Per Share / Book Value Per Share
Significance: Assists in determining if a stock is overpriced or undervalued.