Financial ratio
Encyclopedia
A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statement
s. Often used in accounting, there are many standard ratios 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
s (owners) of a firm, and by a firm's creditor
s. Security 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
, 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; 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%.
, income statement
, statement of cash flows or (sometimes) the statement of retained earnings
. 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 organization.
. 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. Debt ratios measure the firm's ability to repay long-term debt. 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.
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.
Financial ratios allow for comparisons
Ratios generally hold no meaning unless they are benchmark
ed 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.
s. Most public companies
are required by law to use generally accepted accounting principles
for their home countries, but private companies, partnership
s and sole proprietorship
s may not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards
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.
. Sales
reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice
. Net income
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 Shareholder's 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.
ratios measure the availability of cash to pay debt.
.
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 Market Ratios
Sector-specific ratios
Many formal methods are used in capital budgeting, including the techniques such as
Financial statement
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
s. Often used in accounting, there are many standard ratios 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
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
s (owners) of a firm, and by a firm's creditor
Creditor
A creditor is a party that has a claim to 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 or service to the second party under the assumption that the second party will return an equivalent property or...
s. Security analyst
Financial analyst
A financial analyst, securities analyst, research analyst, equity analyst, or investment analyst is a person who performs financial analysis for external or internal clients as a core part of the job.-Job:...
s use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
, the market price of the shares is used in certain financial ratios.
Ratios can be expressed as a decimal
Decimal separator
Different symbols have been and are used for the decimal mark. The choice of symbol for the decimal mark affects the choice of symbol for the thousands separator used in digit grouping. Consequently the latter is treated in this article as well....
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
Earnings yield
Earnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio.The earnings yield is quoted as a percentage, allowing an easy comparison to going bond rates.-Applications:...
, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
; 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
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.
Sources of data for financial ratios
Values used in calculating financial ratios are taken from the balance sheetBalance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
, income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
, statement of cash flows or (sometimes) the statement of retained earnings
Statement of retained earnings
The Statement of Retained Earnings are basic financial statements.The statements explain the changes in a company's retained earnings over the reporting...
. These comprise the firm's "accounting statements" or financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
. The statements' data is based on the accounting method and accounting standards used by the organization.
Purpose and types of ratios
Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysisFinancial statement analysis
Financial statement analysis is the process of understanding the risk and profitability of a firm through analysis of reported financial information, particularly annual and quarterly reports....
. 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. Debt ratios measure the firm's ability to repay long-term debt. 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.
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.
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 hold no meaning unless they are benchmark
Benchmarking
Benchmarking is the process of comparing one's business processes and performance metrics to industry bests and/or best practices from other industries. Dimensions typically measured are quality, time and cost...
ed 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 or follow various standard accounting practiceStandard accounting practice
Standard accounting practices require publicly-traded companies to follow certain accounting rules when presenting financial statements so that the readers of the statements can easily compare different companies...
s. Most public companies
Public company
This is not the same as a Government-owned corporation.A public company or publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating in over the counter markets...
are required by law to use generally accepted accounting principles
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
for their home countries, but private companies, partnership
Partnership
A partnership is an arrangement where parties agree to cooperate to advance their mutual interests.Since humans are social beings, partnerships between individuals, businesses, interest-based organizations, schools, governments, and varied combinations thereof, have always been and remain commonplace...
s and sole proprietorship
Sole proprietorship
A sole proprietorship, also known as the sole trader or simply a proprietorship, is a type of business entity that is owned and run by one individual and in which there is no legal distinction between the owner and the business. The owner receives all profits and has unlimited responsibility for...
s may not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
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 InternetInternet
The Internet is a global system of interconnected computer networks that use the standard Internet protocol suite to serve billions of users worldwide...
. Sales
Sales (accounting)
In bookkeeping, accounting, and finance, Net sales are operating revenues earned by a company when it sells its products. Revenue are reported directly on the income statement as Sales or Net sales....
reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice
Invoice
An invoice or bill is a commercial document issued by a seller to the buyer, indicating the products, quantities, and agreed prices for products or services the seller has provided the buyer. An invoice indicates the buyer must pay the seller, according to the payment terms...
. Net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
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 Shareholder's 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
Controlling interest
Controlling interest in a corporation means to have control of a large enough block of voting stock shares in a company such that no one stock holder or coalition of stock holders can successfully oppose a motion...
), multiplied by each share's book value. It is important to make this distinction when calculating ratios.
Other abbreviations
(Note: These are not ratios, but values in currency.)- COGSCost of goods soldCost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
= Cost of goods sold, or cost of sales. - EBITEBITEBIT may refer to:*EBIT, or Earnings before interest and taxes, in finance*EBIT, or Electron beam ion trap, in physics*An ebit, a two-party quantum state with quantum entanglement and the fundamental unit of bitpartite entanglement...
= EarningsNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
before interestInterestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
and taxes - EBITDAEBITDAEBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is a non-GAAP metric that is measured exactly as stated. All interest, tax, depreciation and amortization entries in the income statement are reversed out from the bottom-line net income...
= Earnings before interest, taxes, depreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
, and amortizationAmortizationAmortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used... - EPSEarnings per shareEarnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
= Earnings per share
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 marginGross marginGross margin is the difference between revenue and cost before accounting for certain other costs...
, Gross profit margin or Gross Profit Rate
-
- OR
- Gross margin
-
- Operating marginOperating marginIn business, operating margin — also known as operating income margin, operating profit margin and return on sales — is the ratio of operating income divided by net sales, usually presented in percent....
, Operating Income Margin, Operating profit margin or Return on sales (ROS)
- Operating margin
- 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 taxesEarnings before interest and taxesIn accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
/ Sales)
-
- Profit marginProfit marginProfit margin, net margin, net profit margin or net profit ratio all refer to a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue.Net profit Margin = x100...
, net margin or net profit margin
- Profit margin
-
- Return on equityReturn on equityReturn on equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity . ROE shows how well a company uses investment funds to generate earnings growth...
(ROE)
- Return on equity
-
- Return on investmentReturn on investmentReturn on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
(ROI ratio or Du Pont Ratio)
- Return on investment
-
- Return on assets (ROA)
-
- Return on assets Du Pont (ROA Du Pont)
-
- Return on Equity Du Pont (ROE Du Pont)
-
- Return on net assetsReturn on net assetsThe return on net assets is a measure of financial performance of a company which takes the use of assets into account.-Formula:Return on net assets = Profit after tax /...
(RONA)
- Return on net assets
-
- Return on capital (ROC)
-
- Risk adjusted return on capitalRisk adjusted return on capitalRisk adjusted return on capital 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 Bankers Trust and principal designer Dan Borge in the late 1970s...
(RAROC)
-
- OR
- Risk adjusted return on capital
-
- Return on capital employed (ROCE)
-
- Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity
-
- Cash flow return on investmentCash flow return on investmentCash flow return on investment is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings.CFROI = Cash Flow / Market Recapitalization...
(CFROI)
- Cash flow return on investment
-
- Efficiency ratioEfficiency ratioThe efficiency ratio, a ratio that is typically applied to banks, in simple terms is defined as expenses as a percentage of revenue , with a few variations. A lower percentage is better since that means expenses are low and earnings are high...
- Efficiency ratio
-
- Net gearing
-
- Basic Earnings Power Ratio
Liquidity ratios
LiquidityAccounting liquidity
In accounting, liquidity is a measure of the ability of a debtor to pay his debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.-Calculating liquidity:...
ratios measure the availability of cash to pay debt.
-
- Current ratio (Working Capital Ratio)Current ratioThe current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities...
- Acid-test ratio (Quick ratio)Quick ratioIn finance, the Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their...
- Cash ratio
- Operation cash flowOperating cash flowIn financial accounting, operating cash flow , cash flow provided by operations or cash flow from operating activities , refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities...
ratio
- Current ratio (Working Capital Ratio)
Activity ratios (Efficiency Ratios)
Activity ratios measure the effectiveness of the firms use of resources.-
- Average collection periodDebtor collection periodThe term Debtor Collection Period indicates the average time taken to collect trade debts. In other words, a reducing period of time is an indicator of increasing efficiency. it enables the enterprise to compare the real collection period with the granted/theoretical credit period.Debtor Collection...
- Average collection period
-
- Degree of Operating Leverage (DOL)
-
- DSO RatioDSO RatioDSO ratio, or days sales outstanding ratio, or days' sales outstanding ratio, is a financial ratio that illustrates how well a company's accounts receivables are being managed.A DSO ratio can be expressed as:...
.
- DSO Ratio
-
- Average payment period
-
- Stock turnover ratio
-
- Receivables Turnover RatioReceivables turnover ratioReceivable Turnover Ratio is one of the accounting activity ratios, a financial ratio. This ratio measures the number of times, on average, receivables are collected during the period. A popular variant of the receivables turnover ratio is to convert it into an Average Collection Period in terms...
- Receivables Turnover Ratio
-
- Inventory conversion ratio
-
- Inventory conversion period (essentially same thing as above)
-
- Receivables conversion period
-
- Payables conversion period
- Cash Conversion CycleCash conversion cycleIn management accounting, the Cash Conversion Cycle measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth...
Debt ratios (leveraging ratios)
Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
.
-
- Debt to equity ratioDebt to equity ratioThe debt-to-equity ratio 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...
- Debt to equity ratio
-
- Long-term Debt to equity (LT Debt to Equity)
-
- Times interest-earned ratio / Interest Coverage Ratio
-
- OR
-
- Debt service coverage ratioDebt service coverage ratioThe debt service coverage ratio , also known as "debt coverage ratio," is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt payments...
- 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 shareEarnings per shareEarnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
(EPS)
- Earnings per share
-
- Payout ratio
-
- OR
-
- Dividend coverDividend coverDividend cover is the ratio of company's earnings over the dividend paid to shareholders, calculated as earnings per share divided by the dividend per share...
(the inverse of Payout Ratio)
- Dividend cover
-
- P/E ratio
-
- Dividend yieldDividend yieldThe dividend yield or the dividend-price ratio on a company stock is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage...
- Dividend yield
-
- Cash flow ratio or Price/cash flow ratioPrice/cash flow ratioThe price/cash flow ratio , is a ratio used to compare a company's market value to its cash flow...
- Cash flow ratio or Price/cash flow ratio
-
- Price to book value ratioP/B ratioThe price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book value to its current market price. The calculation can be performed in two ways, but the result should be the same each way. In the first way, the company's market capitalization can be divided by the...
(P/B or PBV)
- Price to book value ratio
-
- Price/sales ratioPrice/sales ratioPrice-to-sales ratio, P/S ratio, or PSR, is a valuation metric for stocks. It is calculated by dividing the company's market cap by the company's revenue in the most recent year; or, equivalently, divide the per-share stock price by the per-share revenue.Unless otherwise stated, P/S is "trailing...
- Price/sales ratio
-
- PEG ratioPEG ratioThe PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share , and the company's expected growth....
- PEG ratio
Other Market Ratios
-
- EV/EBITDAEV/EBITDAEV/EBITDA is a valuation multiple used in finance and investment to measure the value of a company. This important multiple is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.An advantage of this multiple is that it is capital...
- EV/EBITDA
-
- EV/SalesEV/SalesEnterprise Value/Sales is a financial ratio that compares the total value of the company to its sales. Generally, the lower the ratio, the cheaper the company is. Some investment professionals believe—as enterprise value and sales both consider debt and equity holders—Enterprise Value/Sales is...
- EV/Sales
-
- 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 valueNet present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
- Profitability indexProfitability indexProfitability index , also known as profit investment ratio and value investment ratio , is the ratio of payoff to investment of a proposed project...
- Internal rate of returnInternal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
- Modified Internal Rate of ReturnModified Internal Rate of ReturnThe modified internal rate of return is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size...
- Equivalent annuityEquivalent Annual CostIn finance the equivalent annual cost is the cost per year of owning and operating an asset over its entire lifespan.EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespans...
See also
- List of valuation topics
- Greeks (finance)Greeks (finance)In mathematical finance, the Greeks are the quantities representing the sensitivities of the price of derivatives such as options to a change in underlying parameters on which the value of an instrument or portfolio of financial instruments is dependent. The name is used because the most common of...
- Capital budgetingCapital budgetingCapital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing...