Financial ratios also known as accounting ratios are numerical values calculated by the using the information available on a firm’s financial statements. These values are essential in summarizing the overall health of a company.
The three core financial statements are:
- Statement of profit or loss also known as income statement – shows a company’s profit over a period.
- Statement of financial position or balance sheet – shows the company’s assets, liabilities and shareholders’ equity.
- Statement of cash flow – shows information of the cash a company generated or used over a given period. This statement has three parts: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities.
Financial ratio analysis is widely used by shareholders, banks and creditors, the management of the business as well as the competitors to assess and compare companies’ performances.
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The comparison can be over a period or across an industry. Comparing ratios of firms in the different industries will be misleading because the level of risk will differ greatly. The comparison over a period shows whether a company’s performance is improving or deteriorating.
Financial ratios are grouped into several categories;
- Profitability ratios
- Market value ratios
- Liquidity ratios
- Leverage ratios
- Efficiency ratios
Financial ratio is broad topic, however I will narrow the discussion to the basic and frequently used ratios.
Profitability ratios: these ratios measures the performance of company’s management team and how well they can convert sales revenue into profit.
It also measures how well a company utilizes its assets, and shareholders’ equity in generating earnings and as well the management of its operating costs.
Just like all ratios, comparing these over a period would indicate whether the performance and profitability of a company were improving or worsening.
Common profitability ratios:
Gross profit margin: shows how much profit a company makes after paying for cost of goods.
Gross profit margin (%): = (gross profit/sales revenue)*100
Operating profit margin shows how a company’s profitability from its operations before the removal of interests and taxes. It helps investors to know how the company were able to manage its cost of operations.
Operating profit margin = (Operating profit/sales revenue)*100
Net profit margin shows how much net income/net profit the company generated from its revenue.
The limitation of net profit margin is that it can be influenced by one-off items such as the sale of an asset, which would temporarily boost profits.
Net profit margin (%): = (net profit/sales revenue)*100
Return on Assets ratio (ROA); this ratio measures how efficiently a company is utilizing its asset, in other words it measures a firm’s profitability in relation to its total assets.
ROA = Net profit / Total assets
Return on Equity ratio (ROE): this ratio measures how well a business is using its equity to generate profit.
ROE = Net profit / Shareholder’s equity
Shareholders equity is the total value of assets less total value of liabilities. The aim
of most businesses is to increase the shareholders’ equity by raising the value of the business’s assets more than any increase in the value of liabilities.
The higher these values are, the more profitable the company is.
Market value ratios
These ratios are used by investors to evaluate the share price of publicly traded companies. Investors use these ratios to analyse whether share price of a company is correctly valued, overvalued or undervalued so as to make informed decision about investing in the stocks of the company.
Some of these ratios are:
Earnings per share ratio (EPS): measures the amount of income earned for each outstanding share. Note that if a company has zero or negative earnings (loss), the company’s EPS will also be zero or negative.
Price Earnings ratio (P/E): measures the current price of a company’s share in relation to its EPS. A high P/E ratio can imply that a company’s stock is overvalued or that investors are expecting the company to grow in the future and vice versa.
Price-earnings ratio = Share price / Earnings per share
Dividend yield: this shows in percentage how much a company pays in dividends in relation to its share price.
Dividend yield = (Dividend per share / Share price)*100
In the next article we will discuss the Liquidity and Leverage ratios.
Ifunanya Ikueze is an Engineer, Safety Professional, Writer, Investor, Entrepreneur and Educator.