Financial Ratios: Definition, Formulas, Types, And Examples

Analyzing different aspects of financial statements helps us calculate different financial ratios easily as it provides various metrics that help investors analyze the financial health of a company and whether or not to invest in the company. Let us understand financial ratios in detail and their significance in this article.

What are Financial Ratios?

Financial Ratios: Key Takeaways

• Financial ratios are calculated by analyzing financial statements. 
• It is broadly divided into three major categories i,e profitability ratio, valuation ratio, and leverage ratio.
• Financial ratios help investors compare companies based on their performance, market cap, and competitors.

Significance of Financial Ratios

• Financial ratios help analyze company performance over a specific period of time. 
• These ratios also help evaluate different companies of different sizes in the same sector based on their industry benchmarks.
• Know whether the stock of a particular company is overvalued or undervalued based on various financial ratios such as the P/E ratio, DE ratio, PEG, PS Ratio, and much more.
• Lenders and creditors use financial ratios to assess whether a company can pay debts back or not. For example, debt to asset, and debt-to-equity ratios are used to determine the financial risks of lending the company.
• Return on Asset and inventory management signifies how well the company is managing its assets.
• Price to Earning Ratio and Price to Book Ratio help analyze market risk by comparing companies based on their valuation and earnings.

Types of Financial Ratios: Broad Classification

1. Profitability Ratios

• Operation Ratio: Operation Ratio is obtained by dividing the expense of an organization by its operating income. It measures what percentage of a company’s revenue is left after paying for variable costs of production, such as raw materials, products, wages, etc. It is represented by the formula given below.
• Net Profit Margin: This ratio is obtained by dividing net income by net sales in a company. This percentage evaluates the net profit that remains after covering all expenses. 
• Return on Capital Employed (ROCE): This ratio is used to measure how efficiently a company uses its capital to make a profit. This ratio takes into account both equity and debt to get a comprehensive view of capital utilization. A higher ROCE indicates that a company 

2. Valuation Ratio

• Price to Earning Ratio (P/E Ratio): This indicates how much investors are willing to pay related to its per-share earnings. The lower the PE ratio more attractive the investment potential. The formula for the PE ratio is obtained by dividing the market share value by earnings per share. 

• Price to Sale Ratio (P/S Ratio): The price-to-sale ratio represents the value of a company’s stock to its revenue. It can be obtained by dividing the market capitalization value of a company by its total revenue/sales. A good PS ratio is below one. The lower the value of the PS ratio more better is to invest in that company.
• EBITDA Ratio: EBITDA stands for Enterprise before Interest, Taxes, Depreciation, and Amortization. This ratio represents how efficient a company’s operation model is. It measures the total overall value of a company excluding taxes, depreciation, interest, etc.

3. Leverage Ratio

• Debt to Equity Ratio (D/E Ratio): This ratio represents the total debt of a company it is using to finance its operations or assets to its total shared equity. It is obtained by dividing the total debt by the total equity. 

• Debt to Assets Ratio (D/A Ratio): This ratio is obtained by dividing a company's total debt from its various assets. It represents how much debt a company carries as compared to the total assets it owns. For a normal small or mid-sized company DA ratio of 1 or less is considered good. 
• Equity Ratio: This ratio indicates that a company is using debts to fulfill its requirement for assets. The higher the Equity ratio more is the financial risk for long-term investing in the company. 

Some More Major Financial Ratios 

1. Return on Equity (RoE Ratio)

• • The higher the ROE, the better the chance for investors to get higher returns on their investments.
  • A higher ROE also represents good cash flow within the company. 
  • ROE = Net Profit/Shareholders Equity*100
  • A higher ROE represents a higher level of management performance. 
  • The DuPont identity is used to break down the RoE into three major components. Check the formula below.

• The formula for DuPont’s identity cancels out each other to return the original formula for RoE but it helps to analyze various aspects of shareholder’s equity. For example, the Net income of a company is Rs 500,000 and the shareholder’s equity is INR 2,000,000. We can calculate the ROE for the company using the metrics above ROE = 500,000/2,000,000 X 100 = 25%
• This ROE represents that for every amount of shareholder’s equity, the company generates 25 percent of profit over the current financial year. This is a strong indicator of the company’s profitability.

2. PAT Margin

• • PAT is used in Annual reports
  • It does not consider other expenses such as depreciation, finance costs, and others at an operating level.
  • All expenses are deducted from the total revenue of a company to identify the company’s overall profitability.
  • PAT Margin = [PAT/Total Revenues]

3. Return on Assets (RoA)

• • A return on investment is the amount of profit generated over an asset or investment over time. It might be in percentage or price change.
  • RoA = Net Income/Average Total Assets where, Net income = Earnings Before Taxes (EBT) - Taxes

Major Breakthrough in Financial Ratios

• Financial ratios are not singular criteria for measuring business health; they are a collective approach to determining the suitability of investing in a business.
• It is one of the best methods to compare a company’s competitors and develop an opinion.
• A higher RoE is better if the debt of the company is not higher.
• The higher the value of RoE the better the chance of higher returns.
• DuPoint helps to analyze RoE after breaking it down into three major categories to analyze the debt factor.
• Financial ratios are more effective when they are compared to different companies in the same sector.

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