4️⃣ Breaking Down Financial Ratios and Their Categories

Financial or accounting ratios turn raw financial data into standardized figures that measure a company’s profitability, efficiency, and its ability to meet financial obligations.

 

📶 Financial or Accounting Ratios

Financial ratios are based on accounting figures such as revenue, net income, debt, and equity, and are calculated from a company’s financial statements, such as:

• Balance Sheet -An overview of a company’s financial status at a specific point in time
• Income Statement -Shows the company's financial performance (income and earnings) over a period of time
• Cash Flow Statement -Tracks the movements of cash entering and leaving the company over the Income Statement period

These ratios can indicate how well or poorly a company is being managed, but also be used to compare the fair value of different companies or entire industries.

1. When analyzing a specific company, the denominator in a financial ratio might be the share price or the company’s market capitalization. 
2. Market capitalization is calculated by multiplying the share price by the total number of outstanding shares.
3. When analyzing entire industries, the denominator can be the total market capitalization of the industry, calculated by adding up the market caps of all listed companies within that sector.

🔍 Insights Provided by Financial Ratios

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🗃️ Four (4) Major Categories of Financial Ratios

 

(1) Balance Sheet Ratios –Measuring Financial Stability (Liquidity and Solvency)

Balance sheet ratios assess a company’s financial stability over time and are important for equity investors. Here are some key balance sheet ratios:

(i) Debt-Equity Ratio

The Debt-Equity Ratio shows a company’s debt level by comparing its liabilities (debt) to the amount shareholders have invested as capital (equity).

■ Debt-Equity Ratio = Total Liabilities / Total Equity

These ratios are important too:

■ Debt Ratio = Total Liabilities / Total Assets

■ Equity Ratio = Total Equity / Total Assets

 

(ii) Current Ratio

The Current Ratio shows a company’s ability to meet its liabilities. A higher Current Ratio means the company is better able to pay off its current and future obligations.

■ Current Ratio = Current Assets / Current Liabilities

 

(iii) Quick Ratio

The quick ratio shows a company’s liquidity and its ability to meet short-term obligations.

■ Qucik Ratio = ( Cash + Cash Equivalents ) / Current Liabilities

 

(iv) Accounts Receivable Turnover

The Accounts Receivable Turnover shows how well a company collects money owed to it. This ratio is important because some companies may use poor sales policies to attract clients. Sales only matter if the company gets paid.

■ Accounts Receivable Turnover = Net Sales / Average Accounts Receivable

 

(v) Times Interest Earned

The Times Interest Earned ratio shows a company’s ability to pay its interest expenses.

■ Times Interest Earned = Earnings Before Interest & Taxes / Interest Expense

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(2) Operating Ratios -Measuring Performance

Operating ratios are used to assess how well a company performs during a specific financial period.

 

(i) Gross Margin

The gross margin shows the gross profit earned on each dollar of sales.

■ Gross Margin = (Revenue - Cost of Goods Sold) / Revenue

 

(ii) Operating Profit Margin

The operating profit margin shows how efficiently a company makes a profit after covering production costs, but before paying interest or taxes. It can be calculated using EBITDA.

■ Operating Margin = Operating Earnings / Revenue​​

■ EBITDA is the company’s total earnings before interest, depreciation, taxes, and amortization.

 

(iii) Net Profit Margin

Net profit margin shows a company’s overall ability to generate earnings for its shareholders. It measures the share of operating profit in sales. If the net profit margin stays strong after using borrowed funds, the company’s growth is likely stable and sustainable.

■ Net profit margin = Profit After Tax / (Revenue X 100)

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(3) Efficiency Ratios –Measuring Efficiency

Efficiency ratios show how well a company uses its resources.

 

(i) Total Asset Turnover Ratio

Total Asset Turnover Ratio measures how efficiently a company uses its assets to generate sales.

■ Total Asset Turnover Ratio = Annual Revenue / Total Assets

 

(ii) Return on Equity

Return on Equity measures the return on the capital that shareholders have invested. It shows how efficiently management is using that capital.

■ Return on Equity = Profit After Tax / Shareholders’ Equity

 

(ii) Return on Assets

Return on Assets shows how profitable the company’s assets are overall and helps evaluate the long-term efficiency of management.

■ Return on Assets = Profit After Tax / Total Assets

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(4) Valuation Ratios –Measuring Effectiveness

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

 

(i) P/E Ratio

The P/E ratio is the most widely used profitability ratio worldwide. It is simple and reliable but looks at past performance. Since it is a lagging indicator, it can mislead investors because past earnings may not continue in the future. The P/E ratio can be calculated by dividing the Price per Share by Earnings per Share or by dividing the total Market Value by Total Earnings.

■ P/E = Price per Share / Earnings per Share, or alternatively

Alternatively:

■ P/E = Market Cap / Total Earnings

 

(ii) P/E/G Ratio

The P/E/G Ratio is a version of the P/E that combines price over earnings with the company’s past growth rates. If a company is growing quickly, it will be valued better using the P/E/G than with just the P/E. This ratio is especially useful for evaluating technology stocks and companies that invest heavily in Research and Development (R&D).

■ P/E = (Price per Share / Earnings per Share) / Earnings Growth

Alternatively:

■ P/E = (Market Cap / Total Earnings) / Earnings Growth

 

(iii) Dividend Yield

Dividend Yield shows the annual cash return per share and is considered an important figure for stock investors.

■ Dividend Yield = Annual Cash per Share / Share Price

 

(iv) Price to Book Value (P/BV)

Price to Book Value (P/BV) compares a company’s book value per share to its price. P/BV is important for valuing financial companies like banks and investment firms, but is less relevant for technology stocks.

■ P/BV = Share Price / Equity Per Share

Alternatively:

■ P/BV = Market Capitalization / Total Equity

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■ G.P. for TradingCenter.org (c)

 

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