Financial ratios compare different line items in the financial statements to yield insights into the condition and results of a business. These ratios are most commonly employed by individuals outside of a business, since employees typically have more detailed information available to them. Nonetheless, senior managers must be conversant with the results of their key financial ratios, so that they can discuss the ratios with members of the investment community, creditors, and lenders.
Financial ratios can be used to compare companies within an industry, since they generally have approximately the same operating models and use roughly the same proportions of assets in relation to their sales volume. The result can be differences in market valuation, as investors reward those companies showing clearly better ratio results than their competitors. The reverse can also occur, where adverse financial ratios can trigger enough shareholder pressure that the board of directors may feel compelled to terminate the employment of the chief executive officer.
Financial ratios are typically divided into the following classifications:
Performance ratios - These ratios compare information on the income statement, and are designed to judge the ability of an organization to generate a profit. Commonly used ratios in this classification include:
- Gross margin ratio. The formula is the gross margin, divided by sales.
- Operating income ratio. The formula is operating income, divided by sales.
- Net profit ratio. The formula is net profit, divided by sales.
Liquidity ratios - These ratios are used to estimate the ability of an organization to pay its bills, and are carefully watched by creditors and lenders. Commonly used ratios in this classification include:
- Days sales outstanding. The formula is accounts receivable divided by annual sales, which is then multiplied by the number of days in the year.
- Current ratio. The formula is current assets, divided by current liabilities.
- Quick ratio. The formula is current assets not including inventory, divided by current liabilities.
Cash flow ratios - These ratios strip away any misleading effects caused by the accrual basis of accounting to reveal the extent to which a business is generating cash. Commonly used ratios in this classification include:
- Cash flow return on assets. The formula is net profit plus non-cash expenses, divided by total assets.
- Cash flow from operations ratio. The formula is cash flow from operations, divided by net income.
- Cash reinvestment ratio. The formula is the increase in the gross amount of fixed assets plus or minus changes in working capital, divided by the aggregation of net income and non-cash expenses.
Return on investment ratios - These ratios reveal the amount of return earned by investors when they invest in a business. Commonly used ratios in this classification include:
- Return on equity. The formula is net income, divided by stockholders' equity.
- Return on assets. The formula is net income, divided by total assets.
There are significant limitations on the use of financial ratios, which are as follows:
- 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.
- The information in a ratio is highly aggregated, and tells little about the underlying dynamics of a business.
- The information reported in a ratio will vary, depending on the accounting policies of a business.