A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in

accounting Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...

, there are many standard

ratio In mathematics, a ratio shows how many times one number contains another. For example, if there are eight oranges and six lemons in a bowl of fruit, then the ratio of oranges to lemons is eight to six (that is, 8:6, which is equivalent to the ...

s used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential

shareholder A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the legal o ...

s (owners) of a firm, and by a firm's

creditor A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property ...

Financial analyst A financial analyst is a professional, undertaking financial analysis for external or internal clients as a core feature of the job. The role may specifically be titled securities analyst, research analyst, equity analyst, investment analyst, ...

s use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a

financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial ma ...

, the market price of the shares is used in certain financial ratios. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its

reciprocal Reciprocal may refer to: In mathematics * Multiplicative inverse, in mathematics, the number 1/''x'', which multiplied by ''x'' gives the product 1, also known as a ''reciprocal'' * Reciprocal polynomial, a polynomial obtained from another pol ...

; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Sources of data

Values used in calculating financial ratios are taken from the

balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...

income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...

statement of cash flows In financial accounting, a cash flow statement, also known as ''statement of cash flows'', is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to op ...

or (sometimes) the

statement of changes in equity A statement of changes in equity and similarly the statement of changes in owner's equity for a sole trader, statement of changes in partners' equity for a partnership, statement of changes in shareholders' equity for a company or statement of cha ...

. These comprise the firm's "accounting statements" or financial statements. The statements' data is based on the accounting method and accounting standards used by the organisation.

Purpose and types

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt. Activity ratios measure how quickly a firm converts non-cash assets to cash assets.Groppelli, p. 436. Debt ratios measure the firm's ability to repay long-term debt.Groppelli, p. 439. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.Groppelli, p. 445. These are concerned with the return on investment for

s, and with the relationship between return and the value of an investment in company's shares. Financial ratios allow for comparisons * between companies * between industries * between different time periods for one company * between a single company and its industry average Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.

Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different

accounting methods A basis of accounting is the time various financial transactions are recorded. The cash basis (EU VAT vocabulary ''cash accounting'') and the accrual basis are the two primary methods of tracking income and expenses in accounting. Both can ...

or follow various standard accounting practices. Most public companies are required by law to use

generally accepted accounting principles Publicly traded companies typically are subject to rigorous standards. Small and midsized businesses often follow more simplified standards, plus any specific disclosures required by their specific lenders and shareholders. Some firms operate on th ...

for their home countries, but private companies,

partnership A partnership is an arrangement where parties, known as business partners, agree to cooperate to advance their mutual interests. The partners in a partnership may be individuals, businesses, interest-based organizations, schools, governments ...

s and

sole proprietorship A sole proprietorship, also known as a sole tradership, individual entrepreneurship or proprietorship, is a type of enterprise owned and run by one person and in which there is no legal distinction between the owner and the business entity. A sol ...

s may elect to not use accrual basis accounting. Large multi-national corporations may use

International Financial Reporting Standards International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's f ...

to produce their financial statements, or they may use the generally accepted accounting principles of their home country. There is no international standard for calculating the summary data presented in all financial statements, and the terminology is not always consistent between companies, industries, countries and time periods.

Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the

Internet The Internet (or internet) is the global system of interconnected computer networks that uses the Internet protocol suite (TCP/IP) to communicate between networks and devices. It is a '' network of networks'' that consists of private, p ...

Sales Sales are activities related to selling or the number of goods sold in a given targeted time period. The delivery of a service for a cost is also considered a sale. The seller, or the provider of the goods or services, completes a sale in r ...

reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an

invoice An invoice, bill or tab is a commercial document issued by a seller to a buyer relating to a sale transaction and indicating the products, quantities, and agreed-upon prices for products or services the seller had provided the buyer. Paym ...

Net income In business and accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest ...

is always the amount ''after'' taxes, depreciation, amortization, and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below). Companies that are primarily involved in providing services with labour do not generally report "Sales" based on hours. These companies tend to report "revenue" based on the monetary value of income that the services provide. Note that Shareholders' Equity and Owner's Equity are ''not'' the same thing, Shareholder's Equity represents the total number of shares in the company multiplied by each share's book value; Owner's Equity represents the total number of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share's book value. It is important to make this distinction when calculating ratios.

Abbreviations

(''Note: '' These are not ratios, but values in currency.) * COGS = Cost of goods sold, or cost of sales. *

EBIT EBIT, Ebit or ebit may refer to: *EBIT, or Earnings before interest and taxes, in finance *EBIT, or Electron beam ion trap, in physics *An ebit (quantum state), a two-party quantum state with quantum entanglement Quantum entanglement is the ph ...

= Earnings before

interest In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...

and taxes * EBITDA = Earnings before interest, taxes,

depreciation In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...

, and amortization * EPS = Earnings per share

Ratios

Profitability ratios

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return :; Gross margin, Gross profit margin or Gross Profit RateWilliams, p. 1094. ::: :::OR ::: :; Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) ::: :::* Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income. (

Earnings before interest and taxes In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and ope ...

/ Sales) :; Profit margin, net margin or net profit marginGroppelli, p. 444. ::: :; Return on equity (ROE) ::: :; Return on assets (ROA ratio or Du Pont Ratio) ::: :; Return on assets (ROA) ::: :; Return on assets Du Pont (ROA Du Pont) ::: :; Return on Equity Du Pont (ROE Du Pont) ::: :; Return on net assets (RONA) ::: :;

Return on capital Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by sharehold ...

(ROC) ::: :;

Risk adjusted return on capital Risk-adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Banker ...

(RAROC) ::: :::OR ::: :; Return on capital employed (ROCE) ::: :::*Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity :; Cash flow return on investment (CFROI) ::: :;

Efficiency ratio The efficiency ratio indicates the expenses as a percentage of revenue (''expenses'' / ''revenue''), with a few variations – it is essentially how much a corporation or individual spends to make a dollar; entities are supposed to attempt minimizi ...

::: :;Net gearing ::: :;Basic Earnings Power Ratio :::

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt. :; Current ratio (Working Capital Ratio)Groppelli, p. 435. ::: :; Acid-test ratio (Quick ratio) ::: :;

Cash ratio Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...

::: :;

Operating cash flow In financial accounting, operating cash flow (OCF), cash flow provided by operations, cash flow from operating activities (CFO) or free cash flow from operations (FCFO), refers to the amount of cash a company generates from the revenues it brings i ...

ratio :::

Activity ratios (Efficiency Ratios)

Activity ratios measure the effectiveness of the firm's use of resources. :; Average collection period :::365 Days :; Degree of Operating Leverage (DOL) ::: :; DSO Ratio. :::365 Days :;Average payment period :::365 Days :; Asset turnover ::: :; Stock turnover ratio ::: :; Receivables Turnover Ratio ::: :;Inventory conversion ratio ::: :;Inventory conversion period (essentially same thing as above) :::365 Days :;Receivables conversion period :::365 Days :;Payables conversion period :::365 Days :;

Cash Conversion Cycle In management accounting, the Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. It is thus a measure of the liquidity risk entailed by grow ...

:::

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure

financial leverage In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever ...

. :; Debt ratio ::: :;

Debt to equity ratio The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two ...

Groppelli, p. 441. ::: :;Long-term Debt to equity (LT Debt to Equity) ::: :; Times interest earned ratio (Interest Coverage Ratio) ::: :::OR ::: :; Debt service coverage ratio :::

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company's shares. :;

Earnings per share Earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock for a company. It is a key measure of corporate profitability and is commonly used to price stocks. In the United States, the Financial Accounti ...

(EPS) ::: :; Payout ratioGroppelli, p. 446.Groppelli, p. 449. ::: :::OR ::: :;

Dividend cover Dividend cover, also commonly known as dividend coverage, is the ratio of company's earnings (net income) over the dividend paid to shareholders, calculated as net profit or loss attributable to ordinary shareholders by total ordinary dividend. So, ...

(the inverse of Payout Ratio) ::: :; P/E ratio ::: :;

Dividend yield The dividend yield or dividend–price ratio of a share is the dividend per share, divided by the price per share. It is also a company's total annual dividend payments divided by its market capitalization, assuming the number of shares is constant ...

::: :;Cash flow ratio or Price/cash flow ratioGroppelli, p. 447. ::: :; Price to book value ratio (P/B or PBV) ::: :; Price/sales ratio ::: :;

PEG ratio The 'PEG ratio' ( price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth. In general, the P/E ratio is h ...

::: Other Market Ratios :; EV/EBITDA ::: :;

EV/Sales Enterprise value/sales is a financial ratio that compares the total value (as measured by enterprise value Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business (i.e. ...

::: :;Cost/Income ratio Sector-specific ratios :;EV/capacity :;EV/output

Capital budgeting ratios

In addition to assisting management and owners in diagnosing the financial health of their company, ratios can also help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion. Many formal methods are used in capital budgeting, including the techniques such as * Net present value * Profitability index *

Internal rate of return Internal rate of return (IRR) is a method of calculating an investment’s rate of return. The term ''internal'' refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or ...

* Modified internal rate of return * Equivalent annuity

References

External links

Stock Valuation Metrics
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