Financial Ratio

Business, Legal & Accounting Glossary

Definition: Financial Ratio




Full Definition of Financial Ratio


In finance, a financial ratio or accounting ratio is a ratio of selected values on an enterprise’s financial statements. There are many standard ratios used to evaluate the overall financial condition of a corporation or other organization. Financial ratios are used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Security analysts use financial ratios to compare the strengths and weaknesses of 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.

Values used in calculating financial ratios are taken from the balance sheet, income statement, cash flow statement and (rarely) statement of retained earnings. These comprise the firm’s “accounting statements” or financial statements.

Ratios are always expressed as a decimal value, such as 0.10, or the equivalent per cent value, such as 10%.

Financial ratios quantify many aspects of a business and are an integral part of 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. 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.

Financial ratios allow for comparisons:

  • between companies
  • between industries
  • between different time periods for one company
  • between a single company and its industry average

The ratios of firms in different industries, which face different risks, capital requirements, and competition are not usually comparable.

Sources Of Data For Financial Ratios

Financial ratios are based on summary data presented in financial statements. This summary data is based on the accounting method and accounting standards used by the organization.

Accounting Methods And Principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships 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 world-wide standard for calculating the summary data presented in all financial statements, and 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. Sales reported by a firm are usually, technically, net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice.

Companies that are primarily involved in providing services based on man-hours do not generally report “Sales” based on man-hours. These companies tend to report “revenue” based in income from services provided.

Profitability Ratios

Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.

Gross margin
Profit margin
Operating margin or Operating income margin = Operating income / Net sales[7]
Net margin
Gross profit margin or Gross profit rate = (Net sales – Cost of goods sold) / Net sales[8]
Operating profit margin or Return on Sales (ROS)
= Earnings before interest and taxes / Sales[9][10]
= Operating earnings / Net sales[11]
Net profit margin = Net profits after taxes / Sales[12]
Return on equity (ROE)
= Net profits after taxes / Stockholders’ equity or tangible net worth [13]
= Net profit / Equity[14]
Return on investment (ROI ratio or Du Pont ratio) = Net income / Total assets[15]
Asset turnover = Sales / Assets[16]
Return on assets (ROA)
Return on net assets (RONA)
Return on capital (ROC)
Risk-adjusted return on capital (RAROC)
Return on capital employed (ROCE)
Cash flow return on investment (CFROI)
Efficiency ratio

Liquidity Ratios

Liquidity ratios measure the availability of cash to pay debt.

  • Current ratio = Current assets / Current liabilities
  • Acid-test ratio (Quick ratio) = (Current assets – Inventories) / Current liabilities
  • Receivables Turnover Ratio = Net credit sales/ Average net receivables
  • Inventory turnover ratio = Cost of goods sold / Average inventory

Activity Ratios

Activity ratios measure how quickly a firm converts non-cash assets to cash assets.

  • Average collection period = Accounts receivable / (Annual credit sales / 360 days)
  • Collection period (period-end)
  • Average payment period = Accounts payable / (Annual credit purchases / 360 days)
  • Inventory turnover ratio = Cost of goods sold / Average inventory
  • Inventory conversion ratio = Inventory conversion to cash period (days) = 360 days / Inventory turnover
  • days Inventory
  • cash conversion cycle

Debt Ratios

Debt ratios measure the firm’s ability to repay long-term debt. Debt ratios measure financial leverage.

  • Debt ratio = Total liabilities / Total assets
  • Debt to assets ratio
  • Debt to equity ratio = (Long-term debt + Value of leases) / Stockholders’ equity
  • Long-term debt/Total asset (LD/TA) ratio = long-term debt / Total assets
  • Times interest-earned ratio = Earnings before interest and taxes EBIT / Annual interest expense
  • Debt service coverage ratio = Net operating income / Total debt service

Market Ratios

Market ratios measure investor response to owning a company’s stock and also the cost of issuing stock.

  • Payout ratio = Dividend / Earnings, or
    = Dividend per share / Earnings per share
    Note: Earnings per share is not a ratio, it is a value in currency. Earnings per share = Expected earnings / Number of outstanding shares
  • P/E ratio = Price / Earnings per share
  • Cash flow ratio or Price/cash flow ratio = Price of stock / present value of cash flow per share
  • Price to book value ratio (P/B or PBV) = Price of stock / Book value per share
  • Price/sales ratio
  • PEG ratio
  • EV/EBITDA

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Definition Sources


Definitions for Financial Ratio are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 23rd April, 2020 | 53 Views.