A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's

financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

s. Often used in

accounting Accounting, also known as accountancy, is the process of recording and processing information about economic entity, economic entities, such as businesses and corporations. Accounting measures the results of an organization's economic activit ...

, 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 corporate stock refers to an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the ...

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 propert ...

Financial analyst A financial analyst is a professional undertaking financial analysis for external or internal clients as a core feature of the job. decimal value, such as 0.10, or given as an equivalent

percentage In mathematics, a percentage () is a number or ratio expressed as a fraction (mathematics), fraction of 100. It is often Denotation, denoted using the ''percent sign'' (%), although the abbreviations ''pct.'', ''pct'', and sometimes ''pc'' are ...

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; 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'', ''statement o ...

, statement of cash flows or (sometimes) the

statement of changes in equity A statement of changes in equity is one of the four basic financial statements. It is also known as 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 ...

. These comprise the firm's "accounting statements" or

financial statements Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

. 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 statement analysis (or just financial analysis) is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, bala ...

. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. * Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. * Liquidity ratios measure the availability of cash to pay debt. * Efficiency (activity) ratios measure how quickly a firm converts non-cash assets to cash assets.Groppelli, p. 436. *

Debt ratio The debt ratio or debt to assets ratio is a financial ratio which indicates the percentage of a company's assets which are funded by debt.Drake, P. P., Financial ratio analysis, p. 9, published on 15 December 2012 It is measured as the ratio of tot ...

s measure the firm's ability to repay long-term debt.Groppelli, p. 439. * 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 In accounting, a basis of accounting is a method used to define, recognise, and report financial transactions. The two primary bases of accounting are the cash basis of accounting, or cash accounting, method and the accrual accounting method. A ...

or follow various

standard accounting practice 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 t ...

s. Most

public companies A public company is a company whose ownership is organized via shares of stock which are intended to be freely traded on a stock exchange or in over-the-counter markets. A public (publicly traded) company can be listed on a stock exchange ( ...

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 t ...

for their home countries, but

private companies A privately held company (or simply a private company) is a company whose shares and related rights or obligations are not offered for public subscription or publicly negotiated in their respective listed markets. Instead, the company's stock is ...

partnership A partnership is an agreement where parties agree to cooperate to advance their mutual interests. The partners in a partnership may be individuals, businesses, interest-based organizations, schools, governments or combinations. Organizations ...

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 only one person and in which there is no legal distinction between the owner and the business entity. ...

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 fi ...

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.

Types of Ratio Comparisons

An important feature of ratio analysis is interpreting ratio values. A meaningful basis for comparison is needed to answer questions such as "Is it too high or too low?" or "Is it good or bad?". Two types of ratio comparisons can be made, cross-sectional and time-series.

Cross-Sectional Analysis

Cross-sectional analysis compares the financial ratios of different companies at the same point in time. It allows companies to benchmark from other competitors by comparing their ratio values to similar companies in the industry.

Time-Series Analysis

Time-series analysis evaluates a company's performance over time. It compares its current performance against past or historical performance. This can help assess the company's progress by looking into developing trends or year-to-year changes.

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 network, global system of interconnected computer networks that uses the Internet protocol suite (TCP/IP) to communicate between networks and devices. It is a internetworking, network of networks ...

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. A period during which goods are sold for a reduced price may also be referred ...

reported by a firm are usually

net sales In bookkeeping, accounting, and financial accounting, net sales are operating revenues earned by a company for selling its products or rendering its services. Also referred to as revenue, they are reported directly on the income statement as ''Sa ...

, which deduct returns, allowances, and early payment discounts from the charge on an

invoice An invoice, bill, tab, or bill of costs is a commercial document that includes an itemized list of goods or services furnished by a seller to a buyer relating to a sale transaction, that usually specifies the price and terms of sale, quanti ...

Net income In business and Accountancy, 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 (a ...

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 A controlling interest is an ownership interest in a corporation with enough voting stock shares to prevail in any stockholders' motion. A majority of voting shares (over 50%) is always a controlling interest. When a party holds less than the maj ...

), 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 =

Earnings {{Short description, Financial term Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are u ...

before

interest In finance and economics, interest is payment from a debtor 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 distinct f ...

and

taxes A tax is a mandatory financial charge or levy imposed on an individual or legal entity by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax co ...

EBITDA A company's earnings before interest, taxes, depreciation, and amortization (commonly abbreviated EBITDA, pronounced ) is a measure of a company's profitability of the operating business only, thus before any effects of indebtedness, state-mandat ...

= Earnings before interest, taxes,

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

, and

amortization Amortization or amortisation may refer to: * The process by which loan principal decreases over the life of an amortizing loan * Amortization (accounting), the expensing of acquisition cost minus the residual value of intangible assets in a syst ...

EPS An extended play (EP) is a Sound recording and reproduction, musical recording that contains more tracks than a Single (music), single but fewer than an album. Contemporary EPs generally contain up to eight tracks and have a playing time of 1 ...

= 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.

Liquidity ratios

Liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quic ...

ratios measure the availability of cash to pay debt.

Efficiency ratios

Efficiency ratios measure the effectiveness of the firm's use of resources.

Debt ratios

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure the level of borrowed funds used by the firm to finance its activities.

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.

Other ratios

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 The net present value (NPV) or net present worth (NPW) is a way of measuring the value of an asset that has cashflow by adding up the present value of all the future cash flows that asset will generate. The present value of a cash flow depends on ...

Profitability index Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amo ...

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 fin ...

Modified internal rate of return The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of unequal size. As the name implies, MIRR is a modification of the internal rate ...

* Equivalent annuity

References

External links

Stock Valuation Metrics
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