By Levan Putkaradze
By Levan Putkaradze
5/5(1)

Types of Financial Ratios: What Do They Tell You?

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Types of Financial Ratios: What Do They Tell You

Finance is an essential cornerstone of global business and economy. Individuals aiming to start a successful business, investment venture or trading practice must have a sound understanding of core financial principles. 

Without the knowledge of financial basics, it will be nigh on impossible to develop effective strategies, make correct business decisions and have sound expectations for the future. This article discusses some of the most valuable and practical financial ratios that anyone in the global business landscape should grasp. 

Key Takeaways

  1. Financial ratios enable companies to simplify business progress analysis and acquire tangible insights into their financial circumstances. 

  2. Ratios present a convenient way to assess complex financial statements and identify potential problems. 

  3. It is essential to remember that even financial ratios could provide faulty and misleading insights. 

What are Financial Ratios?

Financial ratios were invented to simplify complex financial information into swiftly digestible figures, giving financial managers a clear picture of their business progress. Financial ratios are formulas designed to simplify the analysis of financial statements. Without them, statements like profit or loss, balance sheet, and cash flow can be extremely challenging to discern and analyse. 

Thus, experts utilise financial ratios to measure the relationship between various financial figures, determining the progress or regress of company growth, profitability and other important metrics. Calculating ratios in even intervals enables companies to understand the business progress in simple terms.

Moreover, financial ratios uncover hidden business problems not easily identified in financial statements. For example, a particular company could have an increased net profit, more significant cash funds and increased net assets. These numbers are seemingly great, but it is essential to check the debt ratio, as the given company could be achieving better numbers simply by increasing its debt share. As a result, the situation is temporarily favourable, as the mentioned debt will have to be paid at some point in the future. 

It is widely known that companies try to hide their shortcomings in their financial statements by manipulating the financial reports. Thus, experts must check essential financial ratios to analyse and examine financial statements fairly. With their assistance, it will be much harder to conceal the underlying business problems in the financial statements.

Why are Financial Ratios Important?

With ratios, businesses can easily understand their current position and develop strategies to improve their future growth efforts. In simple terms, financial ratios are here to demystify the financial analysis, saving time, money and human resources. Moreover, ratios enable business owners to harness the empirical insights from previous generations and apply them to their specific conditions. 

For example, corporations must continually monitor their Earnings Per Share (EPS) ratio, as it showcases their profitability in the most important lens - compared to their issued shares. With EPS, corporations can swiftly examine their overall progress and determine whether their strategies serve the main purpose of the business. Businesses require different ratios depending on their industry, company structure and key performance indicators. 

Naturally, businesses should not depend on financial ratios entirely, as every company has to deal with unique circumstances. Thus, ratios could fail to emulate the same level of precision and insights for specific companies. Moreover, some ratios can be misleading, as they could paint a pretty picture due to one-off circumstances or inadequate analysis. Thus, it is essential to analyse ratios in the context of unique business conditions and possibly double-check received insights. 

Fast Fact

There are hundreds of financial ratios worldwide, dedicated to specific industries and updated according to the global business environment. 

The Most Prominent Financial Ratios

It is important to note that the field of financial ratios is not static, as it constantly changes according to the ever-evolving business landscape. Thus, aspiring financial analysts must stay in the loop and frequently check for news and updates. However, several core ratios have thus far stood the test of time and remain crucially relevant. Let's recount some of the most critical ones: 

Earnings Per Share (EPS) Ratio

The EPS ratio is one of the most critical metrics in corporate finance. In 2023, most large corporations have made an initial public offering on stock exchanges like Wall Street or London Stock Exchange. Thus, corporations require a reliable metric to analyse their profitability. With EPS, managers can swiftly examine the corporation's effectiveness in consistently achieving the principal goal - increasing shareholders' profits. 

If a corporation reliably increases the EPS figures, more investors will be interested in purchasing and holding their stocks. As a result, their share prices and market capitalisation will increase. Therefore, EPS is a quintessential financial ratio for any company with issued shares. 

How To Calculate EPS Ratio

EPS is calculated by dividing the company's net income by the total common shares issued on the market. However, in some cases, the companies could also feature preferred shares. The holders of these preferred shares have the privilege to receive certain dividends. Thus, companies must exclude the dividends paid to preferred shareholders to achieve an objective EPS ratio. 

How To Calculate EPS Ratio

Working Capital Ratio

It is no secret that most companies require various liabilities to purchase essential materials or services for their routine operations. Thus, most balance sheets include company assets and liabilities. While having bank loans, accounts payable and similar liabilities are not inherently critical, and some companies might accumulate overwhelming amounts of debt. As a result, companies that increase debt without increasing assets could risk becoming illiquid and subsequently insolvent. 

To avoid such consequences, companies must often check the working capital ratio, which indicates how much the company's assets outweigh the current liabilities. The working capital ratio below one is almost always a bad sign for businesses, as they could go bankrupt due to the absence of liquidity. 

After all, some obligations might be payable sooner than expected, and companies should have appropriate resources to honour their liabilities. It is important to note that the working capital ratio pertains to current assets and liabilities, as most long-term liabilities have predictable repayment schedules and thus present fewer liquidity risks in the long term. 

How To Calculate Working Capital Ratio

To calculate working capital, one must divide current assets by current liabilities presented on the balance sheet. Anything from 1.5 is a good number for working capital, as it shows that the company is more than capable of repaying short-term liabilities in a feasible period. 

How To Calculate Working Capital Ratio

Return on Equity (ROE)

Most companies worldwide start with a certain amount of invested capital. The invested capital could be provided from different sources, including business founders, shareholders or angel investors. Regardless of the source, invested capital is utilised to grow the business by acquiring crucial assets and services for operations. 

Thus, it is only logical that investors want to examine the effectiveness of the business compared to their invested capital. This is where the ROE ratio comes into play, calculating how well the company has harnessed the invested resources. Naturally, examining the ROE ratio in the context of a specific industry and competition is required, as different industries have varying levels of capital usage effectiveness. 

For example, eCommerce businesses must have a high ROE ratio, as they do not require massive startup procedures and should generate profits from the get-go. Conversely, capital-intensive industries like construction companies might take several years to create positive ROE numbers. 

How To Calculate Return on Equity Ratio

ROE is calculated by dividing the company’s net income by the total shareholder equity, which is equal to the accumulated amount of invested capital over the company’s lifecycle. A good ROE ratio is generally anything above 20%, but the numbers vary dramatically depending on the specific niche, economic conditions and the company’s current preferences. 

How To Calculate Working Capital Ratio

Final Takeaways

Financial ratios are vital aspects of understanding core business progress swiftly and efficiently. They provide a clear picture of the company's progress and potential shortcomings. Financial analysts utilise ratios to simplify complex financial statements and understandably present the data. 

However, it is essential to remember that financial ratios could be skewed or present misleading information. Thus, analysts and business owners should examine them in the context of their specific business conditions. 

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