FINANCIAL RATIO English meaning

financial ratios definition

With financial leverage ratios, we can get a better idea of a company’s long-term solvency. Financial ratios are only valuable bookkeeping for startups if there is a basis of comparison for them. Each ratio should be compared to past periods of data for the business.

financial ratios definition

The ratios can also be compared to data from other companies in the industry. Ratios generally are not useful 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. First, ratio analysis can be performed to track changes to a company over time to better understand the trajectory of operations.


When comparing an income statement item and a balance sheet item, we measure both in comparable dollars. Notice that we measure the numerator and denominator in cost rather than sales dollars. Inventory turnover relates a measure of sales volume to the average amount of goods on hand to produce this sales volume. Accounts payable turnover shows us how well the company utilizes credit facilities from its suppliers. The higher the inventory turnover ratio, the lower the DOH, and the faster the company converts inventory into sales.

What are the 4 types of financial ratios define?

Financial ratios can be computed using data found in financial statements such as the balance sheet and income statement. In general, there are four categories of ratio analysis: profitability, liquidity, solvency, and valuation.

We exclude less liquid items such as inventory because the company may not be able to convert them into cash immediately. So, when inventory is illiquid, this ratio is a better liquidity indicator than the current ratio. This is because companies are more efficient in using fixed assets to generate revenue.

Why You Can Trust Finance Strategists

How would you determine whether the profit made by XYZ Company last year was good or bad if I told you that it was 5 lakhs? Ratio analysis provides the context needed to calculate profitability. A company’s profitability can be determined by looking at ratios like its gross profit, net profit, and expense ratios, among others. Management can use these ratios to pinpoint and resolve issue areas. Business owners, analysts, investors and other stakeholders review, contrast, and evaluate this financial data in order to make crucial financial decisions.

financial ratios definition

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. To calculate financial ratios, an analyst gathers the firm’s balance sheet, income statement, and statement of cash flows, along with stock price information if the firm is publicly traded. Usually, this information is downloaded to a spreadsheet program.

Operating Margin Ratio

It’s the quantitative relation between two selected numerical values taken from a company’s financial statements. The return on equity measures how much profit a business generates from shareholders’ equity. For instance a company with a declining ROE could be seen as having more risk than a company in the same industry with an increasing ROI. Companies use liquidity ratios to measure working capital performance – the money available to meet your current, short-term obligations .

  • So, it could be a problem if the future demand outlook is strong.
  • This could include looking at profits via profitability ratios, debt levels using solvency ratios, or liquidity ratios.
  • The cash ratio measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities.
  • There are significant limitations on the use of financial ratios.

The two most common asset turnover ratios are inventory turnover and receivables turnover. Financial ratio analysis is used to extract information from the firm’s financial statements that can’t be evaluated simply from examining those statements. There are six categories of financial ratios that business managers normally use in their analysis.

How to calculate financial ratios

Facts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single important event may have been largely responsible for a given relationship. For example, competitors may put a new product on the market, making it necessary for the company to reduce the selling price of a product suddenly rendered obsolete. Such an event would severely affect net sales or profitability, but there might be little chance that such an event would happen again.

Solvency ratios measure the indebtedness of a company by comparing debt levels to assets or equity. The debt ratio is calculated by taking total liabilities divided by total assets. The debt-to-equity ratio is calculated as total liabilities divided by total equity. The receivables turnover ratio is calculated as net credit sales divided by average accounts receivable.