A financial ratio or accounting ratio is a 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 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 In mathematics, a percentage (from la, per centum, "by a hundred") 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.", "p ...

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 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 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 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 th ...

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 (list ...

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 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 the respective listed markets, but rather the company's stock is ...

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 sole ...

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, pub ...

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 ...

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 ''Sal ...

, 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. Payment ...

. 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 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 major ...

), 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 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 used as EBIT (earnings before intere ...

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 A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, o ...

* 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 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 system ...

* 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 margin is the difference between revenue and cost of goods sold (COGS), divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold (e. g. producti ...

, Gross profit margin or Gross Profit RateWilliams, p. 1094. ::: :::OR ::: :;

Operating margin In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income ("operating profit" in the UK) to net sales, usually expressed in percent. ...

, 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 / Sales) :;

Profit margin Profit margin is a measure of profitability. It is calculated by finding the profit as a percentage of the revenue. \text = = There are 3 types of profit margins: gross profit margin, operating profit margin and net profit margin. * Gross Pro ...

, net margin or net profit marginGroppelli, p. 444. ::: :;

Return on equity The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on ''a ...

(ROE) ::: :;

Return on assets The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue. ROA can be computed as below: :\mathrm = \frac This number tells you what the company can do with what it has, ''i.e.'' how many doll ...

(ROA ratio or

Du Pont Ratio DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont framework, DuPont model or the DuPont method) is an expression which breaks ROE (return on equity) into three parts. The name comes from the DuPont company that began usi ...

) ::: :;

(ROA) ::: :;

Return on assets Du Pont DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont framework, DuPont model or the DuPont method) is an expression which breaks ROE (return on equity) into three parts. The name comes from the DuPont company that began usi ...

(ROA Du Pont) ::: :; Return on Equity Du Pont (ROE Du Pont) ::: :;

Return on net assets The return on net assets (RONA) is a measure of financial performance of a company which takes the use of assets into account. Higher RONA means that the company is using its assets and working capital efficiently and effectively. RONA is used by in ...

(RONA) ::: :; Return on capital (ROC) ::: :; Risk adjusted return on capital (RAROC) ::: :::OR ::: :;

Return on capital employed Return on capital employed is an accounting ratio used in finance, valuation, and accounting. It is a useful measure for comparing the relative profitability of companies after taking into account the amount of capital used.Fernandes, Nuno. Finance ...

(ROCE) ::: :::*Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity :;

Cash flow return on investment Cash-flow return on investment (CFROI) is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings. :\text = \frac For the corporation, it is essentially internal rate of return ( ...

(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 Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liq ...

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 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 Degree may refer to: As a unit of measurement * Degree (angle), a unit of angle measurement ** Degree of geographical latitude ** Degree of geographical longitude Longitude (, ) is a geographic coordinate that specifies the east– we ...

(DOL) ::: :;

DSO Ratio In accountancy, days sales outstanding (also called DSO and days receivables) is a calculation used by a company to estimate the size of their outstanding accounts receivable. It measures this size not in units of currency, but in average sales da ...

. :::365 Days :;Average payment period :::365 Days :;

Asset turnover Asset turnover (ATO), total asset turnover, or asset turns is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. Asset turnover is considered to be an Activity ...

::: :;

Stock turnover In accounting, the inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. It is calculated to see if a business has an excessive inventory in comparison to its sales level. The equation ...

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 :::

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 tw ...

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 (EPS) ::: :;

Payout ratio The dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends: :\mbox=\frac The part of earnings not paid to investors is left for investment to provide for future earnings growth. Investors seeking high curr ...

Groppelli, 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 ...

::: Other Market Ratios :; EV/EBITDA ::: :; 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 value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...

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 * Modified internal rate of return * Equivalent annuity

References

External links

Stock Valuation Metrics
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