Business, Legal & Accounting Glossary
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:
The ratios of firms in different industries, which face different risks, capital requirements, and competition are not usually comparable.
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.
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.
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 measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.
Operating margin or Operating income margin = Operating income / Net sales
Gross profit margin or Gross profit rate = (Net sales – Cost of goods sold) / Net sales
Operating profit margin or Return on Sales (ROS)
= Earnings before interest and taxes / Sales
= Operating earnings / Net sales
Net profit margin = Net profits after taxes / Sales
Return on equity (ROE)
= Net profits after taxes / Stockholders’ equity or tangible net worth 
= Net profit / Equity
Return on investment (ROI ratio or Du Pont ratio) = Net income / Total assets
Asset turnover = Sales / Assets
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)
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. Debt ratios measure financial leverage.
Market ratios measure investor response to owning a company’s stock and also the cost of issuing stock.
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This glossary post was last updated: 23rd April, 2020 | 53 Views.