Ratio in general terms refer to as comparison between two values, quantities, things etc and are either expressed using fractions, decimal value, percentage values, use of semi colons like : , and using to in between two numbers. Financial Ratio is a statistical technique used in finding the strength of financial position of a company. It is also used to explore and find possibilities of profit, outcome of profit or loss, strengths and weakness of a company etc. Financial ratios are tools to judge profitability, efficiency, liquidity etc of an organization. This also forms the basis for categorization of the financial ratios. They are also used to present an entity’s performance in the market and the share of investment of the company in present scenario. The following are the types or categories of financial Ratio.
- Profitability Ratio: Profitability ratios act as a foundation or fundamental tool in a company, firm, enterprise, agency, or organization overall profit or rate of return generated with optimum utility of assets with minimal risk and capital involved. They are then further classified into Return on Assets, Return on equity which are calculated on basis of Net Income compared with total assets and the same with shareholder’s equity in case of return on Equity. The higher the ratio better is the profit.
- Efficiency Ratio: Efficiency Ratio are also known in broader sense as Activity Ratios. They determine in general the effectiveness and efficiency of a firm or organization with regard to its utility of available resources. They include Inventory turnover ratio, sales to receivables also known as DSO ratio, return on assets etc. Inventory turnover ratio is generally the statistical measure of number of times an entire stock of inventory is repurchased, sales to receivables or DSO ratio compares trade receivables to revenues in a year. Return on assets is a comparison of net income before taxes to total assets in a year.
- Liquidity or cash rich ratio: Liquidity ratios are generally the ones which determine the availability of cash and cash surplus reserves needed in mitigating debts collected over period of time due to various reasons. Liquidity ratios are of four types: Current or working capital ratio, Acid-test or quick ratio, Cash ratio, Operation cash flow ratio. Current or working capital ratio is measured by comparing/dividing current assets over current liabilities and more the presence of former, better the cash reserves. By the current observation of Thompson Reuter’s firm, general rule of thumb applies for current ratio which is 2:1 means 2. Acid-test, litmus test or quick ratio helps determine companies/firms ability to pay the debts immediately as it is determined by dividing current assets-(Inventories + Prepayments) over current liabilities. Cash ratio determines availability of cash for funding or for removing debts by comparing cash reserves in form of cash or Market securities like shares, debentures which can be converted to cash at later point of time with the current liabilities. Operating cash flow is determined by dividing Operating cash flow in a year divided by the total debts accumulated.
- Debts and Market Ratio’s: Debt ratios measure a business’s debts relative to its equity. Creditors use debt ratios to estimate the risk of lending money to a business; a higher ratio indicates greater debt relative to equity, presenting a greater risk to lenders. The basic debt ratio is measured by simply dividing total liabilities by total assets. Market Ratios measures the return on investments with regard to value of money invested and the current market condition prevailing. Common Market ratios are Earnings per share, Payout ratio, Dividend cover, Profit per earnings ratio. Payout Ratio is a comparison by dividing the total dividends received with respect to total earnings or earnings per share. Earnings per share are the Net earnings received divided by the Number of Shares. Dividend cover is just opposite to payout ratio as it is comparison between total Earnings per share divided with Dividend per share.
Thus financial ratios helps in determining not only the financial condition of a company or organization, it also helps in understanding market conditions, share value, cash and cash reserves to pay the debts or obligations confined on a company and last but not the least to understand the presence of different constraints to maximise returns or profits at a reduced risk and efficient cash flow.