What Is a Financial Ratio?

Financial ratios are the ratios used to reflect the interrelationships between different items and items, between categories, or between two different financial statements, such as related items in the balance sheet and income statement, in the same financial statement . Using financial ratio analysis, you can discover and evaluate the financial status and problems of your business. Investors usually use the following ratios: in analyzing profitability, using indicators of return on assets, return on common equity, net profit margin on sales, earnings per share and other indicators; in analyzing debt serviceability, using current ratios, speed And other indicators such as equity ratios, shareholder equity to debt ratios, etc. ^[1]

Financial Ratios

Financial ratio Generally speaking, the relationship between risk and return is measured by three aspects:

Calculation and understanding of major financial ratios:

Below, we take ABC's financial statements (year-end data) as an example to illustrate the calculation and use of the financial ratios in the above three aspects.

Financial ratios reflecting solvency:

Short-term solvency:

Short-term debt repayment ability refers to the ability of an enterprise to repay short-term debt. Insufficient short-term solvency will not only affect the creditworthiness of the enterprise, increase the cost and difficulty of raising funds in the future, but also cause the enterprise to fall into a financial crisis or even go bankrupt. Generally speaking, an enterprise should repay current liabilities with current assets rather than selling long-term assets. Therefore, the quantity relationship between current assets and current liabilities is used to measure short-term debt repayment ability. Take ABC company as an example:

Current ratio = current assets / current liabilities = 1.53

Quick ratio = (current assets-inventory-pending expenses) / current liabilities = 1.53

Cash ratio = (cash + marketable securities) / current liabilities = 0.242

Current assets can be used to repay current liabilities as well as to pay for the funds needed for daily operations. Therefore, a high current ratio generally indicates that a company's short-term debt-paying ability is strong, but if it is too high, it will affect the efficiency and profitability of the company's funds. There is no law as to how appropriate it is, because companies in different industries have different operating characteristics, which makes their liquidity different; in addition, this is also the proportion of cash, accounts receivable, and inventory in current assets. Relevant because they have different liquidity capabilities. To this end, quick ratios (excluding inventory and pending expenses) and cash ratios (excluding inventory, receivables, prepaid accounts, and pending expenses) can be used to assist the analysis. It is generally believed that the current ratio of 2 and the quick-action ratio of 1 are safer. If the ratio is too high, the efficiency will be low. If it is too low, it may be mismanaged. However, due to the different industries and operating characteristics of enterprises, specific analysis should be made in combination with actual conditions.

Long-term solvency:

Long-term solvency refers to the ability of an enterprise to repay long-term interest and principal. Generally speaking, long-term debt is mainly used for long-term investment. Therefore, it is best to use the income generated by the investment to repay interest and principal. The indicators of debt ratio and interest income multiple are usually used to measure a company's long-term solvency. Take ABC company as an example:

Debt ratio = total debt / total assets = 0.33

Interest income multiples = operating net profit / interest expense = (net profit + income tax + interest expense) / interest expense = 32.2

The debt ratio is also called financial leverage. Since the owner's equity does not need to be repaid, the higher the financial leverage, the lower the protection for creditors. However, this does not mean that the lower the financial leverage, the better, because a certain debt indicates that the manager of the enterprise can effectively use the shareholders' funds and help the shareholders to carry out large-scale operations with less funds. Not making good use of its funds. Generally, a level of financial leverage like ABC is more appropriate.

The interest income multiple examines whether an enterprise's operating profit is sufficient to cover the interest expenses of the year. It analyzes its long-term debt repayment ability from the profitability of the company's operating activities. In general, the larger this ratio, the stronger the long-term solvency. Judging from this ratio, ABC's long-term solvency is strong.

Financial ratios reflecting operating capacity

Operating capacity measures the efficiency of enterprise asset utilization based on the turnover speed of various assets of the enterprise. The faster the turnover rate, the faster the various assets of the enterprise enter the production, sales and other operating links, then the shorter the cycle of income and profit formation, the higher the operating efficiency naturally. In general, the following five indicators are included:

Accounts receivable turnover rate = net credit sales income / average balance of accounts receivable = 17.78

Inventory turnover rate = cost of sales / average inventory balance = 4996.94

Turnover ratio of current assets = net sales revenue / average balance of current assets = 1.47

Turnover rate of fixed assets = net sales revenue / average net fixed assets = 0.85

Turnover rate of total assets = net sales revenue / average total assets = 0.52

Because the numerator and denominator of these turnover rate indicators are from the balance sheet and the income statement, while the balance sheet data is static data at a certain point in time, the income statement data is dynamic data throughout the reporting period. The denominator is consistent in time, and the data taken from the balance sheet must be converted into the average amount for the entire reporting period. Generally speaking, the higher the above indicators, the higher the operating efficiency of the enterprise. But quantity is only one aspect. When analyzing, we should also pay attention to the composition and structure of each asset item, such as the matching of various types of inventory, the quality and applicability of inventory.

Financial ratios reflecting profitability:

Profitability is the core of concern in all aspects, and also the key to the success or failure of an enterprise. Only with long-term profitability can an enterprise truly achieve sustainable operation. Therefore, both investors and creditors attach great importance to the ratio that reflects corporate profitability. Generally use the following indicators to measure the profitability of the company, and then take ABC company as an example:

Gross profit margin = (sales revenue-cost) / sales revenue = 71.73%

Operating profit margin = operating profit / sales income = (net profit + income tax + interest expenses) / sales income = 36.64%

Net profit margin = net profit / sales revenue = 35.5%

Return on Total Assets = Net Profit / Average Total Assets = 18.48%

Return on equity = net profit / average equity = 23.77%

Profit per share = net profit / total shares outstanding = 0.687 (assuming that the company has a total of 10,000,000 shares outstanding)

Among the above indicators, gross profit margin, operating profit margin, and net profit margin respectively indicate the production (or sales) process, business activities, and overall profitability of the enterprise. The higher the profitability, the higher the profitability; the return on assets reflects the common interests of shareholders and creditors Profitability of invested capital; return on equity reflects the profitability of shareholders' invested capital. The return on equity is the content that shareholders are most concerned about. It is related to financial leverage. If the return on assets is the same, the higher the financial leverage, the higher the return on equity of the company, because the shareholders achieve the same profitability with less funds. . Profit per share is just a distribution of net profit to each share, the purpose is to more simply represent the earnings of equity capital. To measure whether the above profitability indicators are high or low, conclusions can usually only be drawn by comparing with the level of other companies in the same industry. In general, ABC's profitability index is relatively high.

For listed companies, because the stocks they issue have price data, an important ratio is generally calculated, which is the price-earnings ratio. Price-earnings ratio = price per stock market / earnings per share, it represents the price that investors are willing to pay for each dollar of profit. On the one hand, it can be used to confirm whether the stock is optimistic, and on the other hand, it is also a measure of the investment cost, which reflects the degree of risk of investing in the stock. Assuming that ABC is a listed company and the stock price is 25 yuan, its price-earnings ratio = 25 / 0.68 = 36.76 times. The higher the ratio, the more investors believe that the company has a greater profit potential and is willing to pay a higher price to buy the company's stock, but at the same time the investment risk is also high. The price-earnings ratio also has certain limitations, because the stock market price is a point-in-time data, and the earnings per share is a period of data. The difference in the caliber of this data and the accuracy of the earnings forecast have brought certain difficulties to investment analysis. At the same time, various factors such as accounting policies, industry characteristics, and man-made operations also make it difficult to unify the caliber of earnings per share, which brings difficulties to accurate analysis.

In practice, we may be more concerned about the future profitability of the enterprise, that is, growth. Good-growth companies have broader development prospects and are therefore more attractive to investors. Generally speaking, companies can predict their future growth prospects through the growth rates of sales revenue, sales profit, and net profit in the past few years.

Sales revenue growth rate = (sales revenue for the current period-sales revenue for the previous period) / sales revenue for the previous period × 100% = 95%

Operating profit growth rate = (sales profit for the current period-sales profit for the previous period) / sales profit for the previous period × 100% = 113%

Growth rate of net profit = (net profit of the current period-net profit of the previous period) / net profit of the previous period × 100% = 83%

From these several indicators, ABC's profitability and growth are relatively good. Of course, when evaluating the growth of an enterprise, it is best to grasp the data of the enterprise for several consecutive years to ensure that the comprehensive judgment of its profitability, operating efficiency, financial risk and growth trend is more accurate.