Financial ratios are used to provide a quick assessment of potential financial difficulties and dangers. Ratios provide you with a unique perspective and insight into the business. If a financial ratio identifies a potential problem, further investigation is needed to determine if a problem exists and how to correct it. Although there are often specific benchmarks attached to ratios to indicate when there is cause for concern, ratios should also be thought of as a continuum from weak to strong with the stronger the ratio the better. Ratios can identify problems by the size of the ratio but also by the direction of the ratio over time.
Liquidity Ratios
Current Ratio - A firm’s total current assets are divided by its total current liabilities. It shows the ability of a firm to meets its current liabilities with current assets.
Quick Ratio - A firm’s cash or near cash current assets divided by its total current liabilities. It shows the ability of a firm to quickly meet its current liabilities.
Net Working Capital Ratio - A firm’s current assets less its current liabilities divided by its total assets. It shows the amount of additional funds available for financing operations in relationship to the size of the business.
Asset Management Ratios
Days Sales Outstanding - A firm’s accounts receivables divided by its average daily sales. It shows the average length of time a firm must wait after making a sale before it receives payment.
Fixed Asset Turnover Ratio - A firm’s total sales divided by its net fixed assets. It is a measure of how efficiently a firm uses its plant and equipment.
Inventory Turnover Ratio - A firm’s total sales divided by its inventories. It shows the number of times a firm’s inventories are sold-out and need to be restocked during the year.
Total Assets Turnover Ratio - A firm’s total sales divided by its total assets. It is a measure of how efficiently a firm uses its assets.
Debt Management Ratios
Debt to Asset Ratio - A firm’s total debt divided by its total assets. It is a measure of how much of the firm is debt financed.
Debt Coverage Ratio or Debt Service Coverage Ratio [DSCR] - A firm’s cash available for debt service divided by the cash needed for debt service. It is a measure of a firm’s ability to service its debt obligations.
Times Interest Earned Ratio [TIE] - A firm’s earnings before interest and taxes [EBIT] divided by its interest charges. It shows a firm’s ability to meet its interest payments. It is also called the interest coverage ratio.
Earnings Before Interest, Taxes, Depreciation, and Amortization [EBITDA] Coverage Ratio - A firm’s cash flow available to meet fixed financial charges divided by the firm’s fixed financial charges. It shows the ability of a firm to meet its fixed financial charges.
Profitability Ratios
Profit Margin on Sales - A firm’s net income divided by its sales. It shows the ability of sales to generate net income.
Basic Earning Power [BEP] - A firm’s earnings before interest and taxes [EBIT] divided by its total assets. It shows the earning ability of a firm’s assets before the influence of taxes and interest [leverage].
Return on Total Assets [ROA] - A firm’s net income divided by its total assets [both debt and equity supported assets]. It shows the ability of the firm’s assets to generate net income. Interest expense is added back to net income because interest is a form of return on debt-financed assets.
Return on Equity [ROE] - A firm’s net income divided by its equity. It shows the ability of the firm’s equity to generate profits.
Return on Investment [ROI] - A firm’s net income divided by the owner’s original investment in the firm.
Earnings per Share - A firm’s net income per share of stock.
Market Value Ratios
Price/Earnings Ratio [P/E] - The price per share of a firm is divided by its earnings per share. It shows the price investors are willing to pay per dollar of the firm’s earnings.
Price/Cash Flow Ratio - The price per share of a firm divided by its cash flow per share. It shows the price investors are willing to pay per dollar of net cash flow of the firm.
Market-to-book value [M/B] - The market value of a firm is divided by its book value.
Don Hofstrand, retired extension value added agriculture specialist,
Financial leverage ratios [debt ratios] measure the ability of a company to meet its financial obligations when they fall due. Financial leverage ratios [debt ratios] indicate the ability of a company to repay principal amount of its debts, pay interest on its borrowings, and to meet its other financial obligations. They also give insights into the mix of equity and debt a company is using.
Financial leverage ratios usually compare the debts of a company to its assets. The common examples of financial leverage ratios include debt ratio, interest coverage ratio, capitalization ratio, debt-to-equity ratio, and fixed assets to net worth ratio.
Financial leverage ratios indicate the short-term and long-term solvency of a company. They give indications about the financial health of a company. These ratios give indications whether the company has got enough financial resources to cover its financial obligations when the creditors and lenders seek their payments.
A company with adverse financial leverages ratios may not be able to cover its debts and therefore may go bankrupt. These ratios can give warnings to the shareholders and directors of potential financial difficulties. The shareholders and directors can take actions to prevent the company from going bankrupt.
Financial leverage ratios help to determine the overall level of financial risk faced by a company and its shareholders. Generally speaking, the greater the amount of debt of a company the greater the financial risk is. A company with greater amount of debts and financial obligations is more likely to fail to repay its debts.
Financial leverage ratios are of little use in isolation. To draw meaningful conclusions about the financial health of a company, trend analysis and industry analysis needs to be done. Trend and industry analysis will tell how well the financial position is being managed. Trend analysis will indicate whether the financial position of a company is improving or deteriorating over time. Industry analysis will indicate how well the company is performing as compared to other companies in the same industry.
Companies need to carefully manage their financial leverage ratios to keep their financial risk at acceptable level. Careful management of financial leverage ratios is also important when seeking loans from banks and financial institutions. Favorable ratios can help the company to negotiate a favorable interest rate.
Asset coverage ratio measures the ability of a company to cover its debt obligations with its assets. The ratio tells how much of the assets of a company will be required to cover its outstanding debts. The asset coverage ratio gives a snapshot of the financial position of a company by measuring its tangible and monetary assets against its financial obligations. This ratio allows the investors to reasonably predict the future earnings of the company and to asses the risk of insolvency.
The capitalization ratio compares total debt to total capitalization [capital structure]. The capitalization ratio reflects the extent to which a company is operating on its equity.
Debt ratio is a ratio that indicates proportion between company's debt and its total assets. It shows how much the company relies on debt to finance assets. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The higher the ratio, the greater risk will be associated with the firm's operation. A low debt ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk.
The debt service coverage ratio [DSCR] has different interpretations in different fields. In corporate finance, for example, the debt-service coverage ratio can be explained as the amount of assessable cash flow to congregate the annual interest and principal payments on debt, not forgetting the sinking fund payments.
The debt-to-equity ratio [debt/equity ratio, D/E] is a financial ratio indicating the relative proportion of entity's equity and debt used to finance an entity's assets.
The debt-to-income ratio can be expressed as a personal finance measure that is helpful in comparing an individual’s debt payments to the income generated by him/her.
Debt/EBITDA is one of the common metrics used by the creditors and rating agencies for assessment of defaulting probability on an issued debt. In simple words, it is a method used to quantify and analyze the ability of a company to pay back its debts. This ratio facilitates the investor with the approximate time period required by a firm or business to pay off all debts, ignoring factors like interest, depreciation, taxes, and amortization.
In finance, equity multiplier is defined as a measure of financial leverage. Akin to all debt management ratios, the equity multiplier is a method of evaluating a company’s ability to use its debt for financing its assets. The equity multiplier is also referred to as the leverage ratio or the financial leverage ratio.
The equity ratio refers to a financial ratio indicative of the relative proportion of equity applied to finance the assets of a company. This ratio equity ratio is a variant of the debt-to-equity-ratio and is also, sometimes, referred as net worth to total assets ratio.
Financial leverage can be aptly described as the extent to which a business or investor is using the borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. It is not that financial leverage is always bad. However, it can lead to an increased shareholders’ return on investment. Also, very often, there are tax advantages related with borrowing, also known as leverage.
Fixed assets to net worth is a ratio measuring the solvency of a company. This ratio indicates the extent to which the owners' cash is frozen in the form of fixed assets, such as property, plant, and equipment, and the extent to which funds are available for the company's operations [i.e. for working capital].
Fixed charge coverage ratio is the ratio that indicates a firm’s ability to satisfy fixed financing expenses such as interest and leases. This means that the fixed charges that a firm is obligated to meet are met by the firm. This ratio is calculated by summing up Earnings before interest and Taxes or EBIT and Fixed charge which is divided by fixed charge before tax and interest.
The interest coverage ratio [ICR] is a measure of a company's ability to meet its interest payments. Interest coverage ratio is equal to earnings before interest and taxes [EBIT] for a time period, often one year, divided by interest expenses for the same time period. The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its EBIT. It determines how easily a company can pay interest expenses on outstanding debt.
A Long Term Debt to Capitalization Ratio is the ratio that shows the financial leverage of the firm. This ratio is calculated by dividing the long term debt with the total capital available of a company. The total capital of the company includes the long term debt and the stock of the company. This ratio allows the investors to identify the amount of control utilized by a company and compare it to other companies to analyze the total risk experience of that particular company.
Long Term Debt to Total Asset Ratio is the ratio that represents the financial position of the company and the company’s ability to meet all its financial requirements. It shows the percentage of a company’s assets that are financed with loans and other financial obligations that last over a year. As this ratio is calculated yearly, decrease in the ratio would denote that the company is fairing well, and is less dependant on debts for their business needs.
Non-current assets to net worth ratio isa measure of the extent of a company's investment in low-liquid non-current assets. This ratio is important for comparison analysis because it is less dependent on industry [structure of company assets] than debt ratio or debt-to-equity ratio.
Total expense ratio [TER] is the ratio between total fund costs and total fund assets. It provides information regarding total costs involved annually for investment funds. The costs include expenses like legal fees, management fees, and other operational expenses. Total Expense Ratio is also called as Expense Ratio.