4 Major Categories of Financial Ratios

 

The financial ratios are used for the evaluation of companies or industries. Usually, financial ratios are used as a tool for comparing different companies and industries in several aspects. These financial aspects include profitability, debt, dividends, book value, and many others.

-In the case of analyzing a company, the financial ratios are usually based on an individual share price

-In the case of analyzing industries, the ratios are based on the aggregate market value {computed for each company, by multiplying the current share price to the total number of shares outstanding}

 

Major Ratio Categories

 

1) Balance Sheet Ratios –Measuring Financial Stability

Balance sheet ratios deriving from a company’s balance sheet and mainly deal with the financial stability of a company over time. The most important Balance Sheet Ratios are:

i) Debt-Equity Ratio

It values the debt exposure of a company by measuring the correlation between the company’s liabilities (debt) to what the shareholders have invested in the past in the form of capital (equity).

 

ii) Current Ratio

It values the ability of a company to meet its short-term obligations deriving from its liabilities. The current ratio is formulated by dividing Currents Assets to Current Liabilities. The higher the Current Ratio is -the higher is the ability of the company to pay off its current and future liabilities.

 

2) Operating Ratios -Measuring Performance

Operating ratios are used for evaluating how a company performs in any given financial period. The most important Operating Ratios are:

i) Operating Profit Margin

This ratio is used to evaluate the company’s ability to make profits and its operating efficiency. It is formulated by (EBIDTA/ Sales) X 100). EBIDTA is the company’s total earnings before interest paid, depreciation, tax paid and amortization.

ii) Net Profit Margin

Net profit margin indicates the company’s ability to generate earnings for its shareholders. If Net Profit Margin is stable even after investing with borrowed funds the company growth is stable -and resources can be fully utilized. Net profit margin measures the proportion of operating profit over sales. It is formulated by Profit After Tax /Sales X 100.

 

 

3) Efficiency Ratios –Measuring Efficiency

Efficiency ratios indicate how effectively a company is using its resources. The most important Efficiency Ratios are:

i) Total asset turnover ratio

Total Asset Turnover Ratio measures how efficiently the assets of the company are utilized. The Total Asset Turnover Ratio is formulated by Annual Sales / Total Assets.

 

ii) Return on Equity

 

Return on Equity measures the return of the capital invested in a company by its shareholders. It can indicate the efficiency of the management. Return on Equity is formulated by Profit After Tax / Shareholders’ Equity.

 

4) Valuation Ratios –Measuring Effectiveness

Valuation Ratios measure how the stock market is evaluating a company based on its financial strength and performance.

i) P/E Ratio

P/E Ratio is the most common ratio used by investors worldwide. It is formulated simply by dividing Market Price per Share to Earnings per Share. It can also be calculated by dividing the total Market Value to the Total Annual Earnings. It is a simple and reliable ratio but it usually looks backward and many times can mislead investors as achieved earnings may be one-off and not repeated in the future.

ii) P/E/G Ratio

P/E/G Ratio is a variation of P/E ratio which measures the price of earnings but keeping in mind also the company/industry growth rates. So a company that it is growing fast is priced better based on P/E/G than a company with the same earnings that it is growing slowly. It is formulated simply by dividing Market Price per Share/Earnings per Share/Growth. This ratio is very useful to evaluate technology stocks and companies that invest hugely in Research and Development (R&D).

 

 

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