A financial ratio is a relationship between particular groups of assets or liabilities of an enterprise and corresponding totals of assets or liabilities, or between assets or liabilities and flows like turnover or revenue.
A leading example is the price/earnings ratio which is the ratio of the current quoted stock exchange price of an equity to the most recent declared dividend per share.
Another is the ratio of equity to debt finance (gearing ratio) within a company's overall capital structure.
Financial ratios are used to give summary indications of the financial performance, prospects or strength of a company which help financial managers to make a comparison of a firm's financial condition over time or in relation to other firms.
No single financial ratio can answer all questions analysts may have.
In fact, five different groups of ratios have been developed:
a) liquidity ratios indicating a firm's ability to meet short-term financial obligations;
b) activity ratios indicating how efficiently a firm is using its assets to generate sales;
e) financial leverage ratios indicating a firm's capacity to meet short- and long-term debt obligations;
d) profitability ratios measuring how effectively a firm's management generates profits on sales, assets, and stockholders' investments;
e) market-based ratios measuring the financial market's evaluation of a company's stock.
Russian: Are there any guidelines which enable the businessman to conduct his affairs efficiently and profitably and to compare his company's performance with those of other companies?
American: Yes, there are. One of the major tools is ratio analysis. Ratios make it easy to see trends, risks and to assess the results. All most important decisions are based on ratios.
R.: What are the most commonly used ratios?
Am.: We in the US operate with three main categories of ratios. We use ratios measuring solvency, efficiency, and profitability.
R.: Could you give some examples of each?
Am.: Yes, sure. Let's begin with measuring solvency.
R.: Solvency is the ability of a firm to meet its short-term liabilities as they come due, isn't it?
Am.: Yes, you are absolutely right. And one of the most commonly used measures of solvency is the current ratio.
R.: How is it found?
Am.: This is the ratio of all current assets, liquid assets, accounts receivable and inventories to current liabilities.
R.: When is a firm considered solvent on this measure?
Am.: If its current ratio is 2 to 1 or above. There is another ratio related to this one. It's the-debt-to-equity ratio. It is found by dividing total debt by the equity.
R.: I see. It's the indebtedness of a firm compared to its equity capital. But it's really more a measure of leverage than a measure of solvency.
Am.: Yes, you are right in a way. A highly leveraged company is one with a high proportion of bank loans to equity. But the ratio has some bearing on solvency, too. A low debt-to-equity ratio makes it easier for a firm to borrow to meet its short-term cash needs.
R.: That's clear. A ratio higher than 1 to 1 would make a firm a risky borrower. And what ratios help to measure a firm's efficiency?
Am.: One such ratio is that of sales to inventory, called the inventory turnover ratio.
R.: We say that stock or inventory has "turned over" when it has been sold and replaced with new stock. If we want to double our profit one way is to double the rate of stock turnover.
Am.: Yes, and this ratio varies widely from one industry to another. We can't say whether the ratio is good or poor until we know the product we are discussing. And now let's turn to measuring profitability.
R.: It's the figure that really matters in the end to any businessman, isn't it?
Am.: Yes, practically there are two measures that compare profit to the capital invested in a firm. One such measure is return on equity and the other is return on assets. Both are very important for investors.
R.: No doubt. Knowing the payback of an investment is important because the earlier the payback, the quicker the money can be reinvested, and also the less the risk investors are exposed to.
Am.: You are right, the ratios show how the capital "works". Investors' decisions totally depend on the ratios.