Financial ratios are mathematical manipulations that help the stakeholders, investors, and creditors, among others to evaluate a company’s financial status. They provide an insight into the current position and help to forecast what to expect in the future. While they are easy to calculate, they can be used as tools of comparison even between companies in distinct industries. They can be used by any type of company, whether small or large.

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**Categories of Financial Ratios**

Financial ratios are broadly categorized in terms of liquidity, market value, profitability, solvency, efficiency, leverage, and coverage. Financial ratio analysis is useful for both internal and external users. Internal users include management, employees, and stakeholders. On the other hand, external users are entities and persons such as; creditors, competitors, investors, government authorities, financial analysts and regulatory agencies.

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## Classification of Ratio Analysis

While ratios used for financial analysis are numerous and different, we can classify them into liquidity ratios, activity ratios, debt ratios, profitability ratios, and market ratios. Below is a closer look at each of these ratios and the further subdivisions present.

**Liquidity Ratios**

These ratios assess the ease of a company to convert its assets into cash to offset its obligations without much difficulty. A company whose inventory, accounts receivable, and trading securities are sufficient, is relatively liquid. Liquidity ratios include:

**Quick ratio (acid test ratio)**

This ratio evaluates the ease in which a company can use its quick assets to offset its short-term liabilities. If the quick ratio is too low, that company might not easily offset its liabilities. An excessively high quick ratio indicates that the company has heavily invested its cash in assets with low returns. Therefore, the quick ratio of the company should be in line with that of the industry.

Quick ratio= (current assets-inventory-prepayments)/ current liabilities.

**Current ratio**

This ratio evaluates the ease in which a company can use its current assets to offset its short-term liabilities.

Current ratio= current assets/ current liabilities

A current ratio greater than 1 implies that the company has more assets than liabilities hence, it can easily offset liabilities. However, if the ratio is less than 1, then the company will experience some difficulty offsetting its current liabilities. Therefore, the greater the current ratio the better for the company.

**Cash ratio**

The cash ratio considers the most liquid current assets, hence a very conservative one. It measures the ease of a company to use cash and its equivalents to offset its short-term liabilities. This ratio is the worst-case scenario if the company has no other way of generating cash. A very high ratio indicates that the resources are underutilized while a relatively low one signals inability to pay off current liabilities.

Cash ratio= cash and cash equivalents/ current liabilities.

**Operating cash flow ratio**

For any given period, how many times can the company offset its current liabilities with the cash generated? The operating cash flow ratio answers that question. The ratio is obtained by dividing the operating cash flow with the current liabilities.

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**Activity ratios (efficiency ratios)**

They help evaluate how well a company utilizes its assets and resources to produce income. The following are some common efficiency ratios.

**Asset turnover ratio**

This ratio is an indicator of how well a company can use its assets to generate sales. Lower ratios signal some inefficiency in the use of assets while higher ratios show efficiency in the use of assets. However, different industries can set their asset turnover ratios that can be used as a basis for comparison. Dividing the net sales by total assets yields the asset turnover ratio.

**Inventory turnover ratio**

It compares the cost of goods sold by a company to the average inventories per period to establish the effectiveness of inventory management. It is obtained by dividing the cost of goods sold (as shown in the income statement) with the average inventory. A higher inventory turnover ratio is more ideal for any given company. To get the average inventories, add the beginning inventories to the ending inventories then divide by two.

**Receivables turnover ratio**

It establishes the number of times a company can convert its accounts receivables into cash within a year. Therefore, it shows a company’s efficiency in collecting debts from its debtors within a given period.

Receivables turnover = net credit sales/ average accounts receivable.

A higher ratio indicates that the company is effectively collecting its debts and converting them to cash.

**Days sales inventory ratio**

It can be defined as the ratio showing the number of days the inventory will be sufficient. It can as well indicate the number of days the inventory remains in stock before being transferred to buyers. To calculate it, divide the number of days in the period (mostly 365 days) by the inventory turnover for the period. Alternatively, use (average inventory/ cost of goods sold)* 365. The lower the ratio, the more effective the company.

**Working capital turnover ratio**

It asses how much of the working capital generates revenue for the company. The higher the ratio, the better for the company. To obtain it, divide revenue by the average working capital whereby the average working capital= (opening working capital+ closing working capital)/2.

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**Solvency Ratios (Leverage Ratios)**

These ratios assess how well a company can offset its long-term obligations and liabilities. These include bank loans, bonds and other credit repayments. The common ratios used include:

**Debt ratio**

It shows how easily a company can offset its liabilities using its assets. The higher the ratio of liabilities as compared to the assets, the greater its leverage and financial risk to creditors.

Debt ratio= total liabilities/ total assets

**Debt to equity ratio**

This solvency ratio shows how much of debts from creditors offset liabilities compared to shareholders’ equity. A lower ratio is more ideal since it shows that the company does not highly dependent on external sources to pay off liabilities.

Debt-equity ratio= total liabilities/ shareholders’ equity

**Interest coverage ratio**

It measures the ability of a company to pay interest obligations on any debt. Higher rates (greater than 1) indicate that the company can comfortably pay off the interest.

Interest coverage ratio= operating income/ interest expenses

**Debt service coverage ratio**

Debt service coverage ratio is calculated by dividing operating income with total debt services, it signifies the ease of a company to pay off its debts. A ratio of less than one indicates insufficient negative cash flows

**Profitability Ratios**

While the liquidity and solvency ratios indicate a company’s financial position, efficiency and liquidity ratios show financial performance. Profitability ratios help to establish whether a company is making a profit from its operations. Profitability ratios include

- Profit margin
- Gross margin ratio
- Operating margin ratio
- Return on assets ratio
- Return on equity ratio
- Return on capital employed ratio

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**Market Ratios**

Market ratios show how a company’s stocks are valued concerning earnings and dividend rates. These ratios include:

- Book value per share ratio
- Dividend yield ratio
- Earnings per share ratio
- Price-earnings ratio
- Dividend payout ratio

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**Ratio Analysis Formulas **

There numerous ratios used to carryout financial statement analysis. The ratios are summarized below.

Category | Ratio | Formula |
---|---|---|

Liquidity ratios | Quick ratio | (Current Assets -Inventory)/(Current Liability) or Quick Assets / Quick Liabilities |

Current ratio | Current Assets / Current Liability | |

Cash ratio | (Cash + Marketable Securities )/ Current Liability | |

Operating cash flow ratio | Operating cash flow/ current liabilities | |

Activity ratios/efficiency ratios | Asset turnover ratio | Net sales / Total assets |

Inventory turnover ratio | Cost of goods sold / Average inventory | |

Receivables turnover ratio | Net credit sales / Average accounts receivable | |

Days sales in inventory ratio | 365 days / Inventory turnover ratio | |

Working capital turnover ratio | Revenue/ average working capital | |

Solvency(leverage) ratios | Debt ratio | Total liabilities / Total assets |

Debt to equity ratio | Total liabilities / Shareholder’s equity | |

Interest coverage ratio | Operating income / Interest expenses | |

Debt service coverage ratio | Operating income / Total debt service | |

Profitability ratios | Gross margin ratio | Gross profit / Net sales |

Operating margin ratio | Operating income / Net sales | |

Return on assets ratio | Net income / Total assets | |

Return on equity ratio | Net income / Shareholder’s equity | |

Return on Capital Employed/ return on investment | Profit Before Interest and Tax / Total Capital Employed | |

Profit margin ratio | Net income/net sales | |

Market ratios | Book value per share ratio | Shareholder’s equity / Total shares outstanding |

Dividend yield ratio | Dividend per share / Share price | |

Earnings per share ratio | Net earnings / Total shares outstanding | |

Price-earnings ratio | Share price / Earnings per share | |

Dividend payout ratio | Total dividends/ net income |

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## Advantages and Disadvantages of Ratio Analysis

**Advantages**

- Simplicity: Ratio analysis compresses the information available in financial statements into a few yet understandable numbers.

- Facilitates comparison: Regardless of the size of the company, ratio analysis makes comparison possible.
- Problem-solving tool: With ratio analysis, companies can identify the underlying problems hence come up with ideal solutions.
- Trend analysis: A company can assess what has been happening in terms of its performance and financial stability over the years.
- It provides a straightforward overview of the entire company at a glance

**Disadvantages**

- It is only sensible if the analysis is made between companies in the same industry
- Ratio analysis does not factor in fluctuation brought about by inflation
- It is a quantitative approach that does not incorporate the qualitative aspects within the company
- Ratio analysis only helps to establish if there is a problem but does not offer relevant solutions.

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