Financial Ratios Definition

Financial ratios definition are ratios derived from the financial statement figures to provide a more meaningful and in-depth analysis. It helps track the company's performance and compare the current data to a previous equivalent period, peer companies, and industry benchmark. Commonly used financial ratios are liquidity ratios, efficiency ratios, profitability ratios, leverage ratios, and market ratios.

Types of Financial Ratios

1.    Liquidity Ratios

Liquidity ratios are used to assess a company's capacity to pay current obligations without the need for additional capital. Examples of liquidity ratios are cash ratio, quick ratio, and current ratio. It evaluates the availability of current assets to pay current liabilities. It can also be utilized in comparing the company's performance to peer competitors and the industry average.

2.    Efficiency Ratios

Efficiency ratios measure how effectively a uses its assets and liabilities. Some ratios that are used to measure efficiency are days inventory, days receivable, and days payable. The manufacturing industry average for days inventory is 50 days, 35 days receivable, and 30 days for days payable. Using these industry benchmarks, as applicable, you can improve your inventory, turnover of cash collections, and pay bills on time to avoid penalties.

3.    Profitability Ratios

Profitability ratios measure a company's capacity to generate profit relative to its assets, equity, revenue, and operating costs. It is one of the financial ratios that investors evaluate as these ratios show how much return they can get from an investment. 

It can generate more valuable results by having comparable ratios from the same previous period or comparison to peer and industry average.

4.    Leverage Ratios (Bank Ratios)

Leverage ratios assess a company's capital structure if it is highly leveraged or financed by mixed debt and equity. These are the most scrutinized ratios by banks and creditors to evaluate if a business can pay its debt when due.

A high leverage company can bring trouble to the owner and investors since business turmoil can significantly affect the business finances. It needs a balance when using debt to finance business operations. You must adequately evaluate if the expected return is higher than the interest rate to provide a company's growth. On the other side, having a very low financial obligation can be suspicious. Either a company is highly risk-averse or has a tight profit margin.

5.    Market Ratios

Market values are used to evaluate public companies' stock prices. Investors look at market values if the stock price of a company they want to invest in is overpriced or under priced. Book Value per Share, Price Earnings Ratio, and the Earnings per Share are the most widely used market ratios.

It is vital to utilize financial ratios to better evaluate your company and for investors and lenders to scrutinize companies before providing capital. Financial ratios make more sense of the financial statement and help you make a better decision.

Understanding the financial ratios definition and their uses can provide you with better financial analysis. You will be more confident in taking actions for improvement and growth.