• Aditya Battu

Introduction to Financial ratios

Updated: Jul 7, 2020

If you are into stocks or analyze financial statements, you might have frequently come across some financial ratios which are used by the company to explain its performance and health

In this post we try to understand what these financial ratios are and their significance in explaining the company's performance

Why are these financial ratios important?

They broadly serve 2 purposes :

  1. Track the performance of the company

  2. Help compare with peers/competitors in the same industry

What are the broad categories of financial ratios?

The financial ratios can be broadly classified into 5 categories, based on their purpose :

  1. Liquidity ratios

  2. Leverage ratios

  3. Efficiency ratios

  4. Profitability ratios

  5. Market value ratios

Let's try to understand each of the above 5 categories of ratios, in brief :

1. Liquidity ratios : Explain the company's ability to repay the short-term debt without raising external capital. This is useful in understanding if the company has enough cash/assets to pay off the monthly debt obligations

Examples : Current ratio, Acid-test ratio, Cash ratio, Operating cash flow ratio

2. Leverage ratios : Evaluate company's debt levels to help us understand if the company has high debt obligations which might hamper the profitability of the company

Examples : Debt ratio, Debt-to-equity ratio, Interest coverage ratio

3. Efficiency ratios : Measure how well the company is using its assets and resources to generate revenue.This has got more to do with optimization of the company's resources in generating revenue and profits

Examples : Asset turnover ratio, Inventory turnover ratio, Receivables turnover ratio

4. Profitability ratios : Measure the company's ability to generate profits, probably one of the most important financial ratios to track the performance of the company

Examples : Gross margin ratio, Operating margin ratio, Return on equity ratio

5. Market value ratios : Evaluate the share price of a company's stock. Helps us understand how the shareholders value the stock in the market and play a key role in identifying stocks that may be overvalued, undervalued or priced fairly

Examples : P/E ratio, EPS ( Earnings per share), Dividend yield

Hope you have now got a flavor of these ratios and why it is important for us to understand them

In the next series of posts, we examine each of these ratios in detail and how they help assess the performance and financial health of a company, with examples. Stay tuned...

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