In general, financial ratios can be broken down into four main categories: 1. Profitability Ratios 2. Liquidity Ratios 3. Leverage Ratios 4. Activity Ratios.
Type # 1. Profitability Ratios:
The main objective of any organization is to earn profit. Profit is both a means and end to the organization. The profitability ratios are used to measure how well a business is performing in terms of profit. The profitability ratios are considered to be the basic bank financial ratios.
In other words, the profitability ratios give the various scales to measure the success of the firm. If a company is having a higher profitability ratio compared to its competitor, it can be inferred that the company is doing better than that particular competitor.
The higher or same profitability ratio of a company compared to its previous period also indicates that the company is doing well. Profitability ratios are also called income statement ratios since most of the items used in their calculations are picked up from the income.
The following are the main types of profitability ratios:
i. Profit Margin Analysis.
ii. Return on Equity.
iii. Return on Assets.
i. Profit Margin Analysis:
The term profit margin refers to the amount of money a company makes after it subtracts the cost of goods sold from the gross revenues. The profit margin is represented as a ratio for benchmarking purposes. A company may use the profit margin ratio to compare it against the profit margin from previous periods or for purpose of comparison to a similar company. The profit margin is calculated by taking profit and dividing it by net sales.
There are three types of profit margin ratios:
(a) Gross Profit Margin:
Gross profit is equal to gross sales minus all the costs directly related to the product or service that was sold. The bulk of these costs include materials, labor, and marketing, manufacturing expenses, and selling costs.
The gross profit margin can be calculated with the following formula:
(b) Operating Profit Margin:
The operating profit amount is obtained by subtracting selling, general and administrative or operating expenses from a company’s gross profit amount. Generally, operating expenses would include such account captions as selling, marketing and administrative, research and development, depreciation, rental properties, etc.
(c) Net Profit Margin:
The net profit margin measures the profit available for distribution amongst shareholders after paying all the expenses during a given period of time.
ii. Return on Equity (ROE):
The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The ROE tells common shareholders how effectively their money is being employed.
The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
iii. Return on Assets (ROA):
This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage.
Type # 2. Liquidity Ratios:
Liquidity reflects the ability of a company to meet its short-term obligations using assets that are most readily converted into cash. Assets that can be converted into cash in a short period of time are referred to as liquid assets. These are listed in financial statements as current assets. Current assets are used to satisfy short-term obligations.
Liquidity ratios measure the amount of cash or investments that can be converted to cash to pay expenses and short-term debts. Liquidity ratios determine company’s ability to meet current liabilities.
The two commonly used liquidity ratios are:
i. Current ratio.
i. Current Ratio:
This ratio measures the ability of an organization to generate cash to meet its short-term obligations.
A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business.
ii. Quick Ratio:
This ratio is also referred to as the acid test. It shows whether the company has enough cash to meet its short-term obligations. The quick ratio excludes inventory and other current assets, which are more difficult to turn into cash.
Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poor collection program for accounts receivable. If it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations.
Type # 3. Leverage Ratios:
Leverage ratios look at the extent that a company has depended upon borrowing to finance its operations. As a result, these ratios are reviewed closely by bankers and investors. Most leverage ratios compare assets or net worth with liabilities. A high leverage ratio may increase a company’s exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns.
Some of the major measurements of leverage include:
i. Debt Ratio:
This ratio measures the portion of a company’s capital that is provided by borrowing i.e., the proportion of assets that are financed by creditors’ funds (debt).
A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. In general, the higher the ratio, the more risk that company is considered to have taken on.
ii. Debt to Equity Ratio:
The debt-equity ratio is another leverage ratio that compares a company’s total liabilities to its total shareholders’ equity. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed.
The more a company’s debt exceeds its net worth, the less likely it is to obtain financing. As this number increases, the company’s ability to obtain financing decreases.
Type # 4. Activity Ratios:
Activity ratios are measures of how well assets are used. Activity ratios or turnover ratios can be used to evaluate the benefits produced by specific assets, such, as inventory or accounts receivable.
The most common activity/turnover ratios are:
i. Inventory Turnover Ratio:
Inventory turnover shows how efficiently the company is managing its inventory i.e., its production, ware-housing, and distribution of product, considering its volume of sales.
It is the ratio of cost of goods sold to inventory.
Higher ratios over six or seven times per year are generally thought to be better, although extremely high inventory turnover may indicate lost sales. A low inventory turnover rate, on the other hand, means that the company is paying to keep a large inventory, and may be overstocking or carrying obsolete items.
ii. Accounts Receivable Turnover Ratio:
This ratio gives a measure of how quickly credit sales are turned into cash. It is the ratio of net credit sales to accounts receivable.
iii. Total Assets Turnover Ratio:
The turnover ratio shows how efficiently a company uses its assets. The measurement shows how quickly and how often an asset (piece of machinery or investment) pays for itself. If an older piece of equipment works more slowly but pays for itself three times in a year, while a newer model takes two years to pay for itself, the owner must reflect on whether the payoff is worth the greater investment. It is the ratio of sales to total assets.