A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies.
Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures.
Financial ratios allow for comparisons:
-between different time periods for one company
-between a single company and its industry average
Ratios generally hold no meaning unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.
Profitability ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.
Activity ratios (Efficiency Ratios)
Activity ratios measure the effectiveness of the firm’s use of resources. Activity ratios measure how quickly a firm converts non-cash assets to cash assets.
These measure the availability of cash to pay debt.
Debt ratios (leveraging ratios)
Debt ratios measure the firm’s ability to repay long-term debt. Debt ratios measure financial leverage.
If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios. Market ratios measure investor response to owning a company’s stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.
If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.