What are financial ratios? Definition and meaning

todayDecember 15, 2021

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financial ratios definition

This metric can tell you how likely a company is to generate profits for its investors. A higher EPS typically indicates better profitability, though this rule works best when making apples-to-apples comparisons for companies within the same industry. First, the information used for a ratio is as of a specific point in time or reporting period, which may not be indicative of long-term trends. Second, the information in a ratio is highly aggregated, and tells little about the underlying dynamics of a business. And finally, the information reported in a ratio will vary, depending on the accounting policies of a business. To effectively interpret financial ratios, it is crucial to compare them with industry averages, conduct trend analysis, and recognize their limitations.

They give investors an idea of a company’s financial health as it relates to a potential burden of debt. Solvency ratios measure a company’s long-term financial viability. These ratios compare the debt levels of a company to its assets, equity, or annual earnings. Analysts rely on current and past financial statements to obtain data to evaluate the financial performance of a company. They use the data to determine if a company’s financial health is on an upward or downward trend and to draw comparisons to other competing firms. Financial ratios are the most common and widespread tools used to analyze a business’ financial standing.

Categories of Financial Ratios

Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. The Library provides full text access to a selection of key business and reference eBooks from leading publishers. EBooks are available to logged-in ICAEW members, ACA students and other entitled users. If you are unable to access an eBook, please see our Help and support advice or contact However, some of the best and perhaps easiest to use tools are frequently misunderstood and avoided by new investors.

financial ratios definition

Investors use average inventory since a company’s inventory can increase or decrease throughout the year as demand ebbs and flows. As an example, if a company has a cost of goods sold equal to $1 million and average inventory of $500,000, its inventory turnover ratio is 2. Investors typically favor a higher ratio as it shows that the company may be better at using its assets to generate income. For example, a company that has $10 million in net income and $2 million in average total assets generates $5 in income per $1 of assets.

Who Uses Financial Ratio Analysis?

The gross margin ratio is calculated as gross profit divided by net sales. This ratio measures the proportion of sales revenue remaining after deducting the cost of goods sold (COGS), indicating the company’s gross profitability and pricing strategy effectiveness. Financial ratio analysis quickly gives you insight into a company’s financial health. Rather than having to look at raw revenue and expense data, owners and potential investors can simply look up financial ratios that summarize the information they want to learn. Some of the important efficiency ratios include the asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover,  and receivables turnover ratio.

Liquidity ratios give investors an idea of a company’s operational efficiency. They also show how quickly and easily a company can generate cash to purchase additional assets or to repay creditors. This need can arise in an emergency situation or in the normal course of business. These ratios are used to assess a business’ ability to generate earnings relative to its revenue, operating costs, assets, and shareholders’ equity over time. Key market prospect ratios include dividend yield, earnings per share, the price-to-earnings ratio, and the dividend payout ratio. Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business.

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It involves the study of economic, industry, and company information. Fundamental analysis can be useful because an investor can determine if the security is fairly priced, overvalued, or undervalued by comparing its true value to its market value. Return-on-equity or ROE is a metric used to analyze investment returns.

  • The ratios also measure against the industry average or the company’s past figures.
  • A financial ratio is a means of expressing the relationship between two pieces of numerical data.
  • Solvency ratios measure an organization’s long-term financial feasibility.
  • A financial ratio is used to calculate a company’s financial status or production against other firms.
  • These ratios are important for businesses, investors, creditors, and other stakeholders as they help in evaluating a company’s financial health, performance, and market position.

Remember, lenders typically have the first claim on a company’s assets if it’s required to liquidate. It’s important to understand the variables that are behind ratios. That’s because a company’s executive or management team has the flexibility to, at times, alter its strategies to make a company’s ratios and stock appear more attractive. A company with a very low profit margin may need to focus on decreasing expenses through wide-scale strategic initiatives.

Why You Can Trust Finance Strategists

With net profit margin, there can be a few red flags you should watch out for. For instance, a company that has decreasing profit margins year-over-year could be dealing with changing market conditions, increasing competition, or rising costs. The higher the ROE, the better the company is at generating profits using shareholder equity.

Written by: Lucia

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