Different Types of Financial Ratios in Business and their Significance

It is difficult for any business owner to go through their company's entire balance sheet and profit and loss statement to understand its performance. It is equally difficult to read the fine print of the competitors' financial charts.

So, the best way is to request financial ratios from your accountant. These ratios are calculated on the numbers extracted from your company's P&L statement, balance sheet, and cash flow statement. The ratio illustrates the company's profitability, leverage, liquidity, and market valuation. It could also be used to detect red flags. Now that you know the answer to what are financial ratios, let's move to the different types of ratios in the business.
 

Different Types of Ratios in Business

 

1. Working Capital Ratio

   Working capital refers to the funds required by businesses to meet their short-term operational expenses. You can use this ratio to figure out your company's liquidity position. It can help you assess how well you use your free cash reserves. Before we go any further, let's look at this financial ratio formula.
    
   Working Capital Ratio = Current Assets ÷ Current Liabilities 
    
   Here, the current asset includes inventory, trade receivables, cash on hand and bank, and short-term investment. On the other hand, current liabilities include outstanding debts, trade payables, outstanding or due taxes, and other accrued liabilities.
    
   From the business point of view, both the ratio of less than and more than one is not considered good. A working capital ratio of less than one means you don't have enough cash on hand to pay off your debts, such as a business loan. If it is over one, you are not effectively utilising your reserves and are unnecessarily amassing inventory.
    

Also Read: Fundamental Things To Know About Working Capital Loans
 

2. Quick Ratios

   The quick ratio is another way to calculate the company's liquidity. It determines whether your company has sufficient resources to pay off all short-term liabilities without selling its underlying assets/inventory or raising additional financing. Here is the formula for calculating this ratio.
    
   Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities 
    
   A quick ratio of less than one means you don't have enough liquid assets to cover your current liabilities. A low quick ratio indicates that you will sell long-term assets that generate income to cover short-term obligations. Furthermore, if it is much lower than the current ratio, your current asset is purely inventory. 
    
   An ideal ratio is slightly higher than or equal to one. However, if it is much higher than one, you are not reinvesting your money wisely.
    

3. Leverage Ratio

   It is one of the key financial ratios for both businesses and lenders. It assists you in determining how much of your company's capital is self-funded and how much you have raised from private equity or financial institutions. It can also help you figure out how to pay off your long-term debt. You can use this ratio to determine the optimum capital structure and lower the associated costs. The leverage ratio is of two types—capital structure and coverage ratio.
    
   • Capital Structure Ratio: You can use the debt-to-equity formula (Total Liabilities ÷ Total Equity) to arrive at this ratio. 
    
   • Interest Coverage Ratio = Earnings Before Interest and Taxes ÷ Interest Expenses
    

4. Return on Equity (ROE) Ratio

   The return on equity ratio helps you find how much profit your company makes from its shareholders' money. It informs you how effectively you spend the funds received from shareholders. You can further use it to forecast your company's growth rate and as a foundation for strategic planning. The formula for the ROE ratio is as follows:
    
   Return on Equity = Net Income ÷ Equity of Shareholders 
    

5. Price to Earnings Ratio

   Price to Earnings ratio or PE ratio is relevant for investors. If you invest in any company's stock, it will inform you how much money you will need to spend on a single share of that company to make Re 1. Many experts believe that if the company's PE is above 28, the stock is expensive. But, this assertion does not apply to quality stocks. 
    
   Formula:
    
   P/E Ratio = Current Market Value of the Share ÷ Earnings Per Share
    

 

Significance of Financial Ratios

 

1. Understanding Operating Efficiency

   Financial ratio analysis assists in determining if the company is using its resources wisely. It assists you in tracking your company's sales and revenue to capital expenditures, current assets, and current liabilities. You can use these ratios to formulate your sales and marketing strategy. It also helps you identify obsolete assets that are not helping your business generate revenue.
    

2. Risk Identification

   Financial ratios are infamous for predicting the company's success and failure by identifying potential risks. Since it highlights excessive debts, poor cash inflow, negative revenue, and poor stock market performance, you may quickly use these numbers to identify the root cause of any problems.
    

3. Industry Analysis

   Financial ratios allow you to analyse how your peers are performing. It assists you in understanding your competitors' existing debts and how efficiently they are using the funds of investors. You can use these ratios to set a benchmark for your company's performance.
    

Also Read: Financial Management Tips to Help You Improve Business Growth
 

To Conclude

Financial ratios are crucial to your company's success. It benefits you, your investors, and the internal stakeholders of your organisation. You can use these ratios as a foundation for preparing a budget and marketing strategy and assigning tasks to different departments.