**4 Major Categories of Financial Ratios**

The financial ratios are used for the evaluation of companies or industries. Usually, financial ratios are used as a tool for comparing different companies and industries in several aspects. These financial aspects include profitability, debt, dividends, book value, and many others.

-In the case of analyzing a company, the financial ratios are usually based on an individual share price

-In the case of analyzing industries, the ratios are based on the aggregate market value {computed for each company, by multiplying the current share price to the total number of shares outstanding}

**Major Ratio Categories**

**1) Balance Sheet Ratio****s** –Measuring Financial Stability

Balance sheet ratios deriving from a company’s balance sheet and mainly deal with the financial stability of a company over time. The most important Balance Sheet Ratios are:

**i) Debt-Equity Ratio**

**It values the debt exposure of a company by measuring the correlation between the company’s liabilities (debt) to what the shareholders have invested in the past in the form of capital (equity).**

**ii) Current Ratio**

**It values the ability of a company **to meet its short-term obligations deriving from its liabilities. The current ratio is formulated by dividing Currents Assets to Current Liabilities. The higher the Current Ratio is -the higher is the ability of the company to pay off its current and future liabilities.

**2) Operating Ratios **-Measuring Performance

Operating ratios are used for evaluating how a company performs in any given financial period. The most important Operating Ratios are:

**i) Operating Profit Margin**

This ratio is used to evaluate the company’s ability to make profits and its operating efficiency. It is formulated by (EBIDTA/ Sales) X 100). EBIDTA is the company’s total earnings before interest paid, depreciation, tax paid and amortization.

**ii) Net Profit Margin**

Net profit margin indicates the company’s ability to generate earnings for its shareholders. If Net Profit Margin is stable even after investing with borrowed funds the company growth is stable -and resources can be fully utilized. Net profit margin measures the proportion of operating profit over sales. It is formulated by Profit After Tax /Sales X 100.

**3) Efficiency Ratios ****–Measuring Efficiency**

**Efficiency ratios **indicate how effectively a company is using its resources. The most important **Efficiency** Ratios are:

**i) Total asset turnover ratio**

Total Asset Turnover Ratio measures how efficiently the assets of the company are utilized. The Total Asset Turnover Ratio is formulated by Annual Sales / Total Assets.

** **

**ii) Return on Equity**

Return on Equity measures the return of the capital invested in a company by its shareholders. It can indicate the efficiency of the management. Return on Equity is formulated by Profit After Tax / Shareholders’ Equity.

**4) Valuation Ratios ****–Measuring Effectiveness**

**Valuation Ratios measure **how the stock market is evaluating a company based on its financial strength and performance.

**i) P/E Ratio**

**P/E Ratio is the most common ratio used by investors worldwide. It is formulated simply by dividing **Market Price per Share to Earnings per Share. It can also be calculated by dividing the total Market Value to the Total Annual Earnings. It is a simple and reliable ratio but it usually looks backward and many times can mislead investors as achieved earnings may be one-off and not repeated in the future.

**ii) P/E****/G ****Ratio**

**P/E/G Ratio is a variation of P/E ratio which measures the price of earnings but keeping in mind also the company/industry growth rates. So a company that it is growing fast is priced better based on P/E/G than a company with the same earnings that it is growing slowly. It is formulated simply by dividing **Market Price per Share/Earnings per Share/Growth. This ratio is very useful to evaluate technology stocks and companies that invest hugely in Research and Development (R&D).

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