The financial reasons They are key indicators of the financial performance of a company, created with the use of numerical amounts taken from the financial statements in order to obtain important information about an organization.
The numbers found in a company's financial statements, which are balance sheet, income statement, and cash flow statement, are used to perform quantitative analysis and evaluate liquidity, growth, margins, rates of return, leverage, profitability. , and valuation of a company.
When it comes to investing, analyzing financial statement information is one of the most important elements of the fundamental analysis process, if not the most important..
At the same time, the sheer number of numbers in a company's financial statements can be bewildering and intimidating to many investors. However, through the analysis of financial ratios, it will be possible to work with these numbers in an organized way..
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Calculating financial ratios is relatively straightforward. However, understanding and interpreting what they say about a company's financial status requires a little more work..
Established companies often have several years of balance sheet and income statement data to work with reasoning analysis.
Calculating financial ratios for various periods, either quarterly or annually, helps to track useful trends in the company's operational performance..
They are financial ratios that measure the ability of a company to pay its short and long-term financial obligations. The most common financial liquidity ratios include the following.
Current ratio measures the ability of a company to pay short-term liabilities with current assets:
Current ratio = current assets / current liabilities.
The quick ratio measures the ability of a company to pay short-term liabilities with quick assets:
Quick ratio = (current assets - inventories) / current liabilities.
It is a measure of the number of times that a company can pay current liabilities with the cash generated in a given period:
Operating cash flow ratio = operating cash flow / current liabilities.
They measure the amount of equity that comes from debt. In other words, financial leverage ratios are used to evaluate a company's debt levels. The most common financial ratios for leverage include the following:
It measures the relative amount of the assets of a company that are provided thanks to the debt:
Debt to assets ratio = total liabilities / total assets.
The debt-to-equity ratio calculates the weight of total debt and financial liabilities versus stockholders' equity:
Debt to equity ratio = Total liabilities / Shareholders' equity.
The interest coverage ratio determines how easily a business can pay its interest expenses:
Interest coverage ratio = operating income / interest expense.
The debt service coverage ratio determines how easily a business can pay its debt obligations:
Debt service coverage ratio = operating profit / total debt service.
They are also known as financial activity indices. They are used to measure how well a company is using its assets and resources. The most common financial efficiency ratios include the following.
The asset turnover ratio measures the ability of a company to generate sales from assets:
Asset turnover ratio = net sales / total assets.
It measures how many times a company's inventory is sold and replaced in a given period:
Inventory turnover ratio = cost of merchandise sold / average inventory.
Measures the number of times a business can convert accounts receivable to cash during a given period:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable.
The sales days in inventory ratio measures the average number of days a company maintains in its inventory before selling it to customers:
Sales days in inventory = 365 days / inventory turnover ratio.
They measure a company's ability to generate income relative to revenue, balance sheet assets, operating costs, and capital. The most common financial ratios for profitability include the following.
Compare a company's gross profit to its net sales to show how much profit a company makes after paying the cost of merchandise sold:
Gross Profitability Ratio = Gross Profit / Net Sales.
The operating profitability ratio compares a company's operating income to its net sales to determine operating efficiency:
Operating profitability ratio = operating profitability / net sales.
The return on assets ratio measures the efficiency with which a company uses its assets to generate profits:
Return on Assets Ratio = Net Return / Total Assets.
The ratio of return on equity measures the efficiency with which a company uses its equity to generate profits:
Ratio of return on equity = net return / shareholders' equity.
They are used to evaluate the price of a company's shares. The most common market value ratios include the following.
The book value per share ratio calculates the value per share of a company based on the capital available to shareholders:
Ratio of book value per share = stockholders' equity / Total shares outstanding.
The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:
Dividend yield ratio = dividends per share / share price.
The earnings per share ratio measures the amount of net income earned for each outstanding share:
Earnings per share ratio = net earnings / total shares outstanding.
The price-earnings ratio compares the price of a company's stock to earnings per share:
Price-earnings ratio = Share price / Earnings per share.
Financial ratios are the most common and widespread tools for analyzing the financial situation of a company. The reasons are easy to understand and easy to calculate. They can also be used to compare different companies in different industries..
Since a ratio is simply a mathematical comparison based on proportions, both large and small companies can use ratios to help them compare their financial information..
In a way, financial ratios do not take into account the size of a company or industry. Ratios are just a rough estimate of financial position and performance.
Financial ratios allow companies from all industries, sizes and sectors to be compared to identify their strengths and weaknesses.
The determination of financial ratios is carried out individually by period, as is the monitoring over time of changes in their values to discover trends that may be developing in a company.
For example, an increase in the debt-to-asset ratio may show that a company is burdened with debt and may eventually face a risk of default..
Comparing the financial ratios with those of the main competitors is done to verify if the company relative to the industry average is performing better or worse..
For example, comparing the return on assets between companies makes it easier for an investor or analyst to determine which company assets are being used most efficiently..
Users of financial ratios include both internal and external parts of the company:
- Internal users are the owners, the management team and employees.
- External users are retail investors, financial analysts, competitors, creditors, regulatory authorities, tax authorities and also industry observers.
The analysis of the financial statements includes the financial ratios. For the ABC company, its balance sheet and income statement are presented:
Here are two financial ratios that are based solely on the amounts of current assets and current liabilities that appear on the ABC company's balance sheet:
Current ratio = current assets / current liabilities = $ 89,000 / $ 61,000 = 1.46.
Quick ratio = (current assets - inventories) / current liabilities = ($ 89,000 - $ 36,300) / $ 61,000 = $ 52,700 / $ 61,000 = 0.86.
The following financial ratio implies the relationship between two balance sheet amounts: total liabilities and total capital:
Debt to equity ratio = Total liabilities / Shareholders' equity = $ 481,000 / $ 289,000 = 1.66.
In this example, for every $ 1 contributed by shareholders, creditors contributed $ 1.66.
The following financial ratios relate the balance sheet amounts of accounts receivable and inventory to amounts in the income statement. To illustrate these financial ratios, we have the following income statement:
Inventory turnover ratio = cost of merchandise sold / average inventory = $ 380,000 / $ 36,300 = 10.47 times.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable = $ 500,000 / $ 40,500 = 12.35 times.
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