Financial ratios are important metrics for analyzing a company’s finances. In rating or stock analyst reports, we will find various ratios. Likewise, banks also use various ratios to measure a company’s financial health. Ratios provide them with a guide for drawing conclusions from the analysis they perform.
In this article, I will describe various financial ratios, including their formulas and interpretations.
What are financial ratios?
Financial ratios are quantitative relationships between two or more numbers in financial statements. Ratio calculation is relatively easy. To calculate it, we divide one financial statement item by another, expressed as a percentage or multiple.
But, the interpretation may not be as simple as the calculation. Ratios must be meaningful and refer to economically important relationships, thus helping us interpret the company’s financial performance and soundness.
Why are financial ratios important?
There are several reasons why financial ratios are important for us in analyzing financial statements. It helps us understand the company’s financial condition and performance, including to:
- Evaluate past performance, such as management’s ability to manage the company’s finances and operations.
- Assess current financial flexibility to support future growth, including those related to capital structure and leverage levels.
- Forecast future cash flows and how quickly a company can convert sales into cash.
- Assess how effective and efficient the company is in generating profits.
- Assess the company’s ability to meet its liabilities (short-term and long-term).
What are the four types of financial ratios?
How to calculate and interpret financial ratios? This article breaks down the ratios by classifying them into four groups, including:
- Efficiency Ratio
- Liquidity ratio
- Solvency ratio
- Profitability ratio
The efficiency ratio tells us how effectively a company manages its assets and liabilities. Of course, we like it when the company is productive and efficient in carrying out day-to-day operations. We also call this the activity ratio, and it includes:
- Inventory turnover
- Days of inventory on hand (DOH)
- Accounts receivable turnover
- Days sales outstanding (DSO)
- Accounts payable turnover
- Days payable outstanding (DPO)
- Working capital turnover
- Fixed asset turnover
- Asset turnover ratio
Inventory turnover shows how well a company manages its inventory. We divide the cost of goods sold (COGS) on the income statement by the average inventory on the balance sheet to calculate it. The formula for calculating inventory turnover is:
- Inventory turnover = Cost of goods sold / Average inventory
Ideally, higher inventory turnover, relative to peers or industry averages, is preferable. It shows effective management in managing inventory.
On the other hand, a low ratio could indicate a problem. For example, companies may stockpile goods in warehouses due to sales problems. Or, the company rebuilds its inventory too quickly even though market demand is still weak.
Yet, a high ratio can also indicate insufficient inventory. So, it could be a problem if the future demand outlook is strong. The company cannot meet demand because of insufficient inventory, so sales are less than optimal.
We can then use the inventory turnover ratio to calculate another financial ratio, namely days of inventory on hand (DOH). It shows us how long it took the company to convert its inventory into sales. The DOH formula is as follows:
- Days of inventory on hand (DOH) = 365 / Inventory turnover
DOH has an inverse relationship with inventory turnover. The higher the inventory turnover ratio, the lower the DOH, and the faster the company converts inventory into sales.
Accounts receivable turnover
Accounts receivable turnover measures how effectively a company manages credit sales. The calculation is easy. We divide the revenue figure on the income statement by the average accounts receivable in current assets. The accounts receivable turnover formula is:
- Accounts receivable turnover = Revenue / Average accounts receivable
Higher accounts receivable turnover is more desirable. It shows the company’s credit collection procedure is efficient.
Conversely, if the receivables turnover is low, the company may be too lax in providing credit. Or it happens because the company is having trouble collecting payments from customers.
But, as a note to us, a high receivables turnover ratio can also occur due to too-strict credit terms or collection policies. It can hurt sales if competitors offer customers more lenient credit terms.
Furthermore, we can also use the accounts receivable turnover ratio to calculate days sales outstanding (DSO). It measures how long it takes the company to collect receivables. To calculate it, we divide the number of days in a year (365 days) by the accounts receivable turnover. Here’s the formula:
- Days sales outstanding (DSO) = 365 / Accounts receivable turnover
DSO is inversely proportional to the accounts receivable turnover ratio. Thus, the higher the receivables turnover ratio, the lower the DSO, indicating the faster a company can collect receivables from customers.
Accounts payable turnover
Accounts payable turnover shows us how well the company utilizes credit facilities from its suppliers. It’s the opposite of the accounts receivable turnover ratio.
To calculate it, we divide the number of purchases by the average accounts payable in current liabilities. Purchase figures are not available on the income statement. Hence, we need to calculate it manually, using the following formula:
- Purchases = Ending inventory + Cost of goods sold – Beginning inventory
Next, to calculate the accounts payable turnover ratio, we can use the following formula:
- Accounts payable turnover = Purchases / Average accounts payable
The formula shows how many times a company pays its suppliers in a year. Thus, a low ratio is desirable because the company obtains more lenient credit terms from its suppliers. So, the company can use the cash for other purposes before paying it to them.
On the other hand, a high ratio may indicate the company is spending too quickly. As a result, it reduces the company’s financial flexibility. Several reasons explain why it happened:
- Companies may not take full advantage of available credit facilities and pay creditors too quickly.
- Suppliers have too strict policies.
- Companies make early payments to get discounts.
Then, we can also use the accounts payable turnover above to calculate the days payable outstanding (DPO). It shows how long the company pays its suppliers. The formula is as follows:
- Days payable outstanding (DPO) = 365 / Accounts payable turnover
The higher the accounts payable turnover, the lower the DPO, indicating it pays its suppliers earlier. For example, the DPO value is 90, which shows us, the average company takes 90 days to pay its suppliers.
Working capital turnover
The working capital turnover ratio measures a company’s ability to use working capital to generate sales. In the calculation, we divide the revenue figure by the average working capital. We can find the revenue numbers on the top row of the income statement. Meanwhile, for working capital, we calculate it by subtracting current assets from current liabilities.
- Working capital turnover = Revenue / Average working capital
A higher working capital turnover ratio is more desirable. A higher ratio indicates the company is efficient in using its working capital to generate revenue.
Fixed asset turnover
Fixed asset turnover shows us how effectively a company uses its fixed assets to generate revenue. Fixed assets consist of property, plant, and equipment (PP&E). We can find it in non-current assets on the balance sheet.
Similar to working capital turnover, we calculate fixed asset turnover by dividing revenue by the average fixed assets. Here is the formula:
- Fixed asset turnover = Revenue / Average fixed assets
A higher ratio indicates better efficiency. This is because companies are more efficient in using fixed assets to generate revenue. Conversely, a low ratio may indicate operating inefficiency.
Asset turnover ratio
The asset turnover ratio highlights the overall operating efficiency. It shows how well management is managing and using assets, both short-term and long-term. The higher the asset turnover ratio, the better.
We calculate the asset turnover ratio by dividing the revenue on the income statement by the average total assets on the balance sheet.
- Asset turnover ratio = Revenue / Average total assets
The liquidity ratio measures the company’s ability to meet its short-term obligations, such as short-term debt and accounts payable. In general, to get the liquidity ratio, we have to divide the accounts in current assets by the total current liabilities. The three commonly used ratios are:
- Current ratio
- Quick ratio
- Cash ratio
Apart from these three, two other ratios for measuring liquidity are:
- Defensive interval ratio
- Cash conversion cycle
The current ratio is the loosest liquidity ratio. We calculate it by dividing current assets by current liabilities.
- Current ratio = Current assets / Current liabilities
This ratio shows us whether the company’s current assets are sufficient to pay its short-term liabilities. A current ratio value equal to 1 is usually a limit, which means current assets are equal to current liabilities. If it is less than one, it can mean the company has a liquidity problem.
We exclude less liquid items such as inventory because the company may not be able to convert them into cash immediately. So, when inventory is illiquid, this ratio is a better liquidity indicator than the current ratio.
In addition, some accounts in current assets also do not represent the potential cash inflows to the company. We also exclude them. Take, for example, prepaid expenses. It represents the money the company has paid to the supplier for supplying the input in the future. Consequently, prepaid expenses represent only future benefits but not future cash inflows.
- Quick ratio = (Cash and cash equivalents + Short term investment + Accounts receivable) / Current liabilities
A higher ratio indicates the more liquid and the better the company’s ability to pay obligations in one operating cycle.
This ratio is the most conservative ratio to measure liquidity. And it is important to measure the company’s liquidity position in case of an unexpected crisis. This is because it only takes cash and cash equivalents into account.
- Cash ratio = Cash and cash equivalents / Current liabilities
As with quick ratios, a higher cash ratio generally means the company has higher liquidity.
Defensive interval ratio
The defensive interval ratio measures the company’s ability to cover daily expenses using the most liquid assets without obtaining additional financing. The higher the ratio, the better.
- Defensive interval ratio = (Cash + Short-term investments + Accounts receivable) / Daily cash outlays
Cash conversion cycle
The cash conversion cycle measures how long it takes a company to convert inventory into cash after adjusting for payments to suppliers. The following is the cash conversion cycle formula:
- Cash conversion cycle = DOH + DSO – DPO
Days sales outstanding (DSO) describes how quickly the company collects payments from customers. Days of inventory on hand (DOH) measures how quickly a company converts inventory into sales. Meanwhile, days payable outstanding (DPO) shows how many days the company pays its suppliers.
Shorter cycles are desirable, indicating better liquidity. This is because the company can convert inventory into cash immediately and pay its suppliers. Conversely, longer cycles indicate lower liquidity.
The solvency ratio is another important financial ratio to measure the company’s financial health. That gives us insight into a company’s ability to pay off long-term obligations, especially long-term interest-bearing debt.
When the company has high debt, we say the company’s financial leverage is high. High leverage is a cause for concern. The company must pay large interest charges regularly, even when they are not generating revenue. It reduces the profit and cash flow of the company.
Then, shareholders also do not like it if the debt is too high. That’s because when the company goes bankrupt, fewer assets are left to them. Hence, the higher the debt, the higher the risk of default and the riskier the stock.
Several ratios are used to measure a company’s solvency, including:
- Debt to asset ratio
- Debt to capital
- Debt to equity
- Interest coverage ratio
Debt to asset ratio
As the name suggests, we calculate the debt to assets ratio by dividing total debt by total assets. We can find these two numbers on the balance sheet. The total debt I mean here is interest-bearing debt, both short-term and long-term.
- Debt to assets ratio = Total debt / Total assets
A higher ratio is undesirable because it implies higher financial risk. It signals a weaker solvency position. It also shows the company’s dependence on debt as its financial capital.
Debt to capital
It measures how much a company depends on debt on its capital structure. Capital includes debt capital and equity capital. Debt has regular outflow consequences (interest payments), whereas equity does not.
- Debt to capital = Total debt / (Total debt + Total equity)
A higher ratio indicates higher financial risk, and therefore, it is not preferred. So, why don’t companies prefer equity over debt?
The company uses debt in its capital composition because it is cheaper. The cost of debt is tax-deductible.
But, too much debt is also not good. The company has to pay interest regularly.
Hence, the company must find the optimal capital structure in which the costs are minimal. Then, to measure the cost of capital, we can use the weighted average cost of capital (WACC).
Debt to equity
The debt to equity ratio (DER) shows how much the company’s debt is relative to equity capital. Again, we can find both in the balance sheet, in the liability and shareholder equity section.
A higher DER ratio is undesirable because it indicates a higher financial risk. DER ratio equal to 1.0 indicates debt capital and equity capital are equivalent in the company’s capital structure.
- Debt to equity (DER) = Total debt / Total equity
However, as I mentioned earlier, even though it is risky, the company still relies on debt as its capital because it is cheaper than equity. So, usually, in some companies, debt capital will be higher than equity capital.
Interest coverage ratio
The interest coverage ratio measures the company’s ability to pay interest. We can calculate it by dividing earnings before interest and tax (EBIT) by interest expense.
EBIT is the profit a company receives from its core business. Financial statements may not be presented separately. Therefore, we have to calculate it ourselves. Here’s the formula:
- EBIT = Revenue – Cost of goods sold – Selling, general and administrative expenses + Interest income + Other income (expenses)
How to calculate EBIT may vary. Some exclude other income (expenses), while others include it. They are usually unstable and may not continue in the future, so some financial analysts prefer to exclude them.
- Interest coverage ratio = EBIT / Interest expense
A higher ratio indicates a better ability to pay interest. Conversely, a ratio close to or less than one indicates the company has serious difficulties paying interest.
The profitability ratio measures the extent to which the company generates a profit. There are two approaches to calculating it.
First, we divide the profit metrics by revenue, which we call the profitability margin. It measures how effective the company is in converting revenue into profit.
Second, we divide net income by balance sheet items, such as assets, equity, and capital. In this case, the ratio shows how high the company’s rate of return is for each asset, equity, and capital used.
Gross profit margin
Gross profit margin shows what percentage of a company’s revenue is left to meet operating and non-operating expenses. We calculate it by dividing gross profit by revenue.
- Gross profit margin = Gross profit / Revenue
A high gross profit margin is more desirable, indicating more money is left to cover indirect costs. A lower ratio indicates the opposite condition.
Gross profit margins vary across industries. It also depends on the competitive strategies adopted by the company. For example, gross profit margin tells us whether the company chooses a differentiation strategy or a cost leadership strategy. To dig deeper, we should compare it to competitors or industry averages.
A differentiation strategy allows the company to earn high margins for each unit sold since it can charge a premium price.
In contrast, a cost leadership strategy promotes a lower cost structure than the industry. The company does not take high margins for each unit sold. Instead, it relies on significant sales volume to increase profitability.
Operating profit margin
The operating profit margin tells us what percentage of dollars the company has left on each sale after paying all operating expenses. It measures how profitable the company’s core business is.
- Operating profit margin = Operating profit / Revenue
A higher operating profit margin is preferred. For example, say the percentage increase is higher than the gross profit margin from year to year. In such cases, it indicates the company’s success in controlling operating costs.
The operating profit margin is more complete and accurate than the gross profit margin in measuring the company’s profitability performance. This is because this ratio considers direct and indirect costs such as selling, general and administrative expenses (SG&A expenses), which represent fixed costs. Companies have to spend money on SG&A expenses, even when the company stops production and makes no sales.
Net profit margin
It measures a company’s ability to generate net profit from each dollar of revenue. Net income takes into account all expenses and revenues. It not only takes into account operating income (expenses), but also non-operating income (expenses) such as sales of fixed assets, interest income (expense), gains (losses), and tax expense.
- Net profit margin = Net profit / Revenue
A higher value is more desirable. We also call it net profit margin or net earning margin.
Return on assets
Return on assets (ROA) measures how well a company uses its assets to generate profits. We measure it by dividing net income by total assets. To avoid variations in asset values due to seasonal factors, we can use the average total assets.
- ROA = Net profit / Average total assets
The higher the ROA, the more able the company to generate net profit from each asset used. And, it is more desirable.
Return on equity
Return on equity (ROE) tells the rate of return obtained by shareholders on the capital they invest in the company. It measures a company’s efficiency in generating profits from equity capital and shows how well it uses it to generate net income. A higher ratio is more desirable.
- ROE = Net profit / Average total equity
We can also use return on common equity (ROCE) as an alternative to ROE. It measures the return to common stockholders. To calculate it, we subtract net income by the preferred dividend. As the numerator, we only use the total common equity capital. Here’s the formula:
- Return on common equity (ROCE) = (Net profit – Preferred dividend) / Average common equity.
How should we use the above ratios?
The above ratios may not be relevant for all industries. So, our first task in financial ratio analysis is to sort them out. Then, we use the ratios most relevant to the industry in which the company operates.
Next is to examine the company’s accounting standards. Different methods produce different numbers. As a result, comparing two companies with different accounting methods can be misleading. Therefore, when comparing them, we must make sure they use the same accounting standards. Or, if different, we make adjustments in the calculations.
Compare with benchmark
Observing only one or two ratios can also be misleading. We can err in concluding, making unobjective judgments. We need references or benchmarks to interpret financial ratios. Benchmarks are important to answer whether the financial ratios in a given year are better or worse.
Two benchmarks we can use:
- Historical trend
- Peers or industry average
For historical trends, we compare the same numbers over time. In this case, we can use their average in the last three or five years as a benchmark.
In my opinion, calculating the average for several years makes more sense than using the previous year as a benchmark. This is because trends from year to year tend to fluctuate due to cyclical factors. And, it can increase our subjectivity if we only use the previous year.
Then, comparing with peers or industry averages is the next benchmark. It is important to answer whether the company is performing better than its competitors. So, for example, a company may record an increase in the ratio from year to year, but it may not outperform competitors.
Take a simple example. The company recorded an increase in net profit margin from year to year, but it was still much lower than competitors. So, although it tends to improve, it is not better than competitors. Then, we need to find out why it happened. Is it due to the company’s poorer operating efficiency and effectiveness or for some other reason?
Read according to context.
Next, we must interpret financial ratios in context. We need to consider aspects such as:
- Management targets
- Economic conditions and business cycle
- Company growth stage
- Industry growth stage
All four affect the company’s business strategy. And it ultimately affects the company’s finances.
Have justification for counting
When one analyst calculates the ratio, the results may differ from other analysts. The reason is because they use different justifications. For example, one analyst may include a specific item. But, others exclude it. Each has a strong and logical reason.
Thus, when we calculate financial ratios, we must know why we use certain items. What is the reason? For example, two analysts may use different accounts to calculate the interest coverage ratio. One uses EBIT as the numerator. Others use earnings before interest, taxes, depreciation, amortization (EBITDA). But, to be sure, both have their own reasons for doing so.
What to read next
- Types of Financial Ratios: Their Analysis and Interpretation
- Activity Ratio: Types, Formulas, and Interpretations
- Liquidity Ratio: Examples, Formulas, How to Calculate
- Solvency Ratio: Formulas, Examples, and Calculations
- Profitability Ratio: Formulas, Types, and Examples
- Valuation Ratio: Formula And Its Interpretation
- Gearing: Meaning, How to Calculate, Pros and Cons
- Financial Ratios For Credit Rating Analysis
- Cash Flow Ratios: Examples, Formulas, and Interpretations
- DuPont Analysis: Formula, Decomposition, Interpretation, Pros, Cons