What Financial Ratios TellYou

What is Financial Ratio

We all have been learning ratios from our early school life. Ratios are simple and easy to ingest but when we talk about Financial ratios we get scared. Believe me !!! its very easy once you grasp the idea of how to interpret it.

What is Financial Ratio?

In Layman's term, it is the health of a firm just like any person' health can be diagnosed with the help of medical report in the same way it shows that how the firm has been performing throughout its financial years. Not only this but these ratios help the firms for future projections. This is an integral part of financial statement analysis.

Why Financial Ratios are important?

It is the important management tool which helps to improve the understanding of financial trends of the firm. This tool is not only important for the management of a firm but also to the outside investors as it provides key indicators of the firm's performance. As a firm manager you want your firm financial status to be healthy and active throughout the years that's why nowadays big corporations are interested in finding their relative internal strength of a firm hence the importance of a clear understanding of financial ratios have increased many folds.

Importance of Financial Ratios


Financial ratios are categorized according to aspects of the business. Following are the main categories of financial ratios:

1. Liquidity Ratios:

These are the ratios which gauge the ability of firms to fulfills its short-term obligations. Usually, all those commitments and obligations which a firm has to meet within one year like A/c payables, Accrued liabilities etc. Liquidity ratios are important for both debtor and creditor point of view. Higher liquidity ratios show that the firm has sufficient ability to obey its short-term obligations, therefore, it increases chances of a firm for being approved for the short-term debt facility from any financial institutions. Usually, the acceptable ratio is 2:1 and you as a financial institution certainly would not want liquidity ratio to be less than 1:1 as it would jeopardize the commitment of the firm. Remember these ratios are industry specific and may vary from industry to industry.
Following are two main liquidity ratios:

  • Current Ratio
  • Quick Ratio

2. Activity Ratios:

Suppose you are the owner of an organization so what important question comes into your mind first. Offcourse !! how efficiently your business's sales are performing. These activity ratios measure the efficiency of the firm in term of its sales. In other words efficiency of the firm in converting its revenue into cash. Usually, it is expressed in times for example Inventory turnover is 35 times, it means firm was able to convert its inventory into cash by selling it 35 times in a year. Some activity ratios are:

  • Inventory turnover ratio.
  • Receivables turnover ratio.
  • Average collection period.
  • Accounts payable turnover ratio.
  • Average payment period.
  • Asset turnover ratio.
  • Working capital turnover ratio.
  • Fixed assets turnover ratio


2. Profitability Ratios:

We know that one of the prime motives for doing business is profit. Yes!!  without earning who would like to do business if it doesn't have any sufficient profits. Profitability ratios are key for any business as it indicates the overall performance of a firm, you can say that it shows the how efficiently a firm is converting its business activity into profits.

Profitability Ratios

The significance of this ratio is very vital for external and internal players. 

  • For external, it shows the profitability of firm to investor and creditors, every investor wants to invest in a profitable business therefore profitable ratios helps the investors to make decisions whether to invest in the firm or not.
  • For internal, it helps the management greatly to make such business decisions like diversifying products, expansion of business etc in order to boost profits.
Profitability ratios are divided into two categories:
Types of Profitability Ratios


4. Market Ratios:

These ratios are critical for investors as it can help them in deciding prices of shares and assessed whether the value of shares are overpriced or not, therefore, they can decide whether to have shares of a firm for short or long time. It also shows the relative strength of shares of a firm in the competitive market.
Market Ratios Financial Ratios


Important market ratios are:
  • Earnings per Share
  • Price Earning Ratio
  • Book Value per Share
  • Dividend Payout Ratio
  • Dividend Yield Ratio
Having sound knowledge of financial ratios is must for every person who is currently or in future will be going to deal in finance. Your career growth depends on how easily and efficiently you can analyze and dig into financial data.

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