Financial Ratio

A financial ratio is a relative magnitude of two selected numerical values taken from a Company’s Financial Statements. There are many standard ratios that can be used to evaluate the overall financial condition of a company. Financial ratios can be used by managers of a firm or shareholders (both current and potential) or banks or anyone else to gauge the financial strength of the company. They can be used also to compare the strengths and weaknesses of two or more organizations.

For Ex: If I were to buy a banking stock from the Indian stock market, I can compare the financial ratios of a few of the country’s leading banks like ICICI, HDFC, SBI etc and then choose the one which I feel has the most impressive financial background and strengths.

Sources of Data for Financial Ratios:

Financial ratios of all company’s can be calculated based on their financial statements that would be declared during their quarterly result announcement. Balance Sheet, Income Statement, Statement of Cashflows, Statement of Earnings etc are some of the documents from which the information required for calculating these financial ratios can be picked up. Also, if the company is listed in the stock market, its current stock price too is used for calculating some of these ratios.

Types of Ratios:

There are many different types of financial ratios that can be calculated based on their purpose. They include:

1. Liquidity Ratios – Ability of the company to pay off debt
2. Activity Ratios – How quickly a firm can convert its non-cash assets to cash assets
3. Debt Ratios – Ability of the firm to repay long-term debt
4. Profitability Ratios – To Measure the firms use of its assets and control of its expenses to generate an acceptable rate of return
5. Market Ratios – To Measure the investor response to owning a company’s stock and also the cost of issuing stock


Use of Financial Ratios:

Financial ratios can be used for comparison
• between two or more companies (ex: comparison between ICICI and HDFC Banks)
• between two or more industries (ex: comparison between the Banking and Auto industry)
• between different time-periods for the same company (ex: comparison on the results of the company in the current financial year and the previous year)
• between a single company and the industry performance

Ratios are generally meaningless unless we benchmark them against something else. Like say past performance or another company. Ratios of firms that operate in different industries, which face different risks, capital requirements, competition, customer demand etc can be very hard to compare.

Terms from a financial statement that will be used in calculation of a ratio:

1. Sales – This refers to the net sales done by the company during the reporting period (After deducting returns, allowances and discounts charged on the invoice)
2. Net Income – Amount earned by the company after taxes, depreciation, amortization and payment of interests
3. COGS – Cost of goods sold or cost of sales
4. EBIT – Earnings before Interest and Taxes
5. EBITDA – Earnings before Interest, Taxes, Depreciation and Amortization
6. EPS – Earnings Per Share

Subsequent articles would involve in depth details about the different types of financial ratios explained in this article.

Please Note: Many of these ratios are complicated and their explanations would run along to pages. I have tried to keep the explanation as short as possible to ensure that the topic does not become boring :)

Happy Reading!!!