Financial Ratio:
A financial ratio is used to calculate a company’s financial status or production against other firms. It is a tool used by investors to analyse and gain information about the finance of a company’s history or the entire business sector. To calculate financial ration, numbers are taken from the balance sheet, income statement, and cash flow statement. The financial ratio is not a calculation but an explanation of the economic status of a company, in terms of profit, liquidity, leverage, and market valuation. A ratio may serve as an indicator, red flag or clue for various issues.
Types of Financial Ratios:
There are fivetypes of financial ratio:
1.Asset turnover ratios: This ratio is used as a guide to optimising the firm’s assets, inventory, and accounts receivable collection on a regular basis. The two common assets are:
- Inventory turnover
- Receivable turnover
2.Dividend turnover ratio: This ratio helps in foresee the company’s future growth. They also give an insight into the company’s dividend policy. The two common dividends are:
- Payout ratio
- Dividend Yield
3.Financial leverage ratio: This ratio gives an idea about the company’s long term debt. Two financial leverage ratios are:
- Debt ratio
- Debt -to-equity-ratio
4.Liquidity Ratio: It gives an understanding of the company’s short term financial obligation.
5.Profitable Ratio: This helps the company to understand how a company is successful in generating profits. Three common profitable are:
- Return on equity
- Return on asset
- Gross profit margin
Uses of Financial Ratios:
The financial ratio can be used in two different forms:
- Analyse firm performance: This performance is evaluated with trend analysis, calculating an individual’s ration on a per-term basis and tracing its worth over time. This analysis is used to find out the source for pending receivables, its average collection time, and a decrease in organisation liquidity status.
- Relative performance comparison: Here, the comparison is between a company’s profits with the other competitors.
The above mentioned is the concept, that is elucidated in detail about ‘What is the Financial Ratio?’ for the Commerce students. To know more, stay tuned to BYJU’S.
Important Topics in Accountancy:
FAQs
In simple words, a financial ratio involves taking one number from a company's financial statements and dividing it by another. The resulting answer gives you a metric that you can use to compare companies to evaluate investment opportunities.
What is the meaning of financial ratios? ›
A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization.
What is an example of a financial ratio? ›
Example: For example, if a company has an operating cash flow of $1 million and current liabilities of $250,000, you could calculate that it has an operating cash flow ratio of 4, which means it has $4 in operating cash flow for every $1 of liabilities.
What are the 5 financial ratios used to determine? ›
Common financial ratios come from a company's balance sheet, income statement, and cash flow statement. Businesses use financial ratios to determine liquidity, debt concentration, growth, profitability, and market value.
What is a financial ratio quizlet? ›
Financial Ratios. - Accounting data stated in relative terms. - Help identify financial strengths and weaknesses of a company by examining: --> Trends across time. --> Comparisons with other firms' ratios.
What are four main types of financial ratios used in ratio analysis? ›
Although there are many financial ratios businesses can use to measure their performance, they can be divided into four basic categories.
- Liquidity ratios.
- Activity ratios (also called efficiency ratios)
- Profitability ratios.
- Leverage ratios.
The common types of ratios in accounting include;
- Profitability ratios. In business, the profitability ratios help managers and investors see whether the company is generating more revenue than expenses. ...
- Leverage ratios. They are the accounting ratios used to show the debts the organization acquired. ...
- Liquidity ratios.
Generally, investors prefer the debt-to-equity (D/E) ratio to be less than 1. A ratio of 2 or higher might be interpreted as carrying more risk. But it also depends on the industry. Big industrial energy and mining companies, for example, tend to carry more debt than businesses in other industries.
How to calculate ratio? ›
Since ratios compare data between two numbers of the same kind, this means your formula would be A divided by B. For instance, if A equals 5 and B equals 10, then your ratio will be 5 divided by 10. Now, you're ready to solve the equation. Divide A by B to find a ratio. In this case, the answer is 0.5.
What is a good debt ratio? ›
If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.
The two key financial ratios used to analyse liquidity are: Current ratio = current assets divided by current liabilities. Quick ratio = (current assets minus inventory) divided by current liabilities.
Which ratio indicate financial risk? ›
The most common ratios used by investors to measure a company's level of risk are the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio.
How is current ratio calculated? ›
Calculating the current ratio is very straightforward: Simply divide the company's current assets by its current liabilities. Current assets are those that can be converted into cash within one year, while current liabilities are obligations expected to be paid within one year.
What is a good current ratio? ›
The current ratio measures a company's capacity to pay its short-term liabilities due in one year. The current ratio weighs a company's current assets against its current liabilities. A good current ratio is typically considered to be anywhere between 1.5 and 3.
What is ratio analysis in simple words? ›
Ratio analysis is a quantitative procedure of obtaining a look into a firm's functional efficiency, liquidity, revenues, and profitability by analysing its financial records and statements. Ratio analysis is a very important factor that will help in doing an analysis of the fundamentals of equity.
How do you calculate the ratio? ›
The ratio of two numbers can be calculated using the ratio formula, p:q = p/q. Let us find the ratio of 81 and 108 using the ratio formula. We will first write the numbers in the form of p:q = p/q. Here 81: 108 = 81/ 108.
