Financial ratios are quantitative tools that analyze a company’s financial performance and position. These ratios are calculated by comparing two or more economic variables, such as revenue and expenses, assets and liabilities, or income and expenditures. By using financial ratios, investors, lenders, and other stakeholders can gain insights into a company’s profitability, liquidity, solvency, and efficiency, among other financial aspects.
Various financial ratios include liquidity, solvency, profitability, and efficiency. Each ratio category provides a different perspective on a company’s financial health and can be used to make an informed investment or credit decisions.
Financial ratios are generally used to assess a company’s financial strength, identify potential risks and opportunities, and compare its performance with other companies in the same industry. However, it is crucial to note that financial ratios are just one tool in a more extensive toolbox of financial analysis and should be used in conjunction with other qualitative and quantitative factors to make informed decisions.
Financial ratios can help lenders evaluate a company’s financial health and creditworthiness. It is important to note that these ratios should be used with other qualitative factors, such as management quality, market conditions, and competitive landscape, to make informed credit decisions. Various ratios are as under.
Debt-to-Equity Ratio:
This ratio assesses a company’s debt and equity financing usage. It is determined by dividing total debt by total equity. A high debt-to-equity ratio implies the firm relies extensively on debt funding, which can raise financial risk and damage creditworthiness.
The Interest Coverage Ratio:
This ratio measures the company’s ability to meet interest expenses on outstanding debt. It is found by dividing earnings before interest and taxes (EBIT) by interest expenses. A high-interest coverage ratio indicates the company has sufficient earnings to cover its interest expenses, which is a positive sign for lenders.
Current Ratio:
This ratio measures the company’s ability to meet its short-term obligations. It is determined by dividing current assets by current liabilities. A high current ratio implies that the firm has enough current assets to pay for its current liabilities, which is a good indicator for lenders.
The Debt Service Coverage Ratio (DSCR):
This ratio measures the company’s ability to meet its debt service obligations, including interest and principal payments. It is calculated by dividing EBITDA (earnings before interest, taxes, depreciation, and amortization) by total debt service. A high DSCR indicates that the company has the sufficient cash flow to meet its debt service obligations.
Gross Profit Margin:
This ratio calculates the proportion of revenue remaining after subtracting the cost of goods sold to determine a company’s profitability. A high gross profit margin suggests that the firm has strong pricing power and is profitable.
Return on Assets (ROA):
This ratio measures the efficiency of a company in utilizing its assets to generate profits. It is obtained by dividing net income by total assets. A high ROA indicates that the company efficiently uses its assets to generate profits.
Return on Equity (ROE):
This ratio measures a company’s profitability in relation to the equity invested by shareholders. It is measured by dividing net income by total equity. A high ROE indicates that the company can generate profits from the equity shareholders invest.
Debt-to-EBITDA Ratio:
This ratio measures the company’s ability to repay its debt using its earnings before interest, taxes, depreciation, and amortization (EBITDA). It is derived by dividing total debt by EBITDA. A lower debt-to-EBITDA ratio indicates the company has less debt concerning its EBITDA, which is a positive sign for lenders.
Inventory Turnover Ratio:
This ratio measures the efficiency of a company’s inventory management. It is estimated by dividing the cost of goods sold by the average inventory determined. A high inventory turnover ratio reflects that the company can sell its inventory quickly, positively impacting cash flow.
Accounts Receivable Turnover Ratio:
This ratio measures the efficiency of a company’s accounts receivable management. It is determined by dividing net credit sales by average accounts receivable. A high accounts receivable turnover ratio shows that the company can collect its receivables quickly, positively impacting cash flow.
Quick Ratio:
This ratio assesses the company’s capacity to satisfy its short-term obligations with its most liquid assets. It is determined by dividing current assets minus inventory by current liabilities. A high quick ratio implies the corporation has enough liquid assets to satisfy its short-term obligations.
Operating Margin:
This ratio measures the profitability of a company’s core operations. It is determined by dividing operating income by revenue. A high operating margin indicates that the company efficiently manages its operating expenses and generates profits from its core operations.
Fixed Charge Coverage Ratio:
This ratio measures the company’s ability to pay its fixed expenses, such as lease payments and loan interest. It is determined by dividing earnings before interest, taxes, depreciation, and amortization (EBITDA) by fixed costs. A higher fixed charge coverage ratio indicates the company has sufficient payments to cover its fixed expenses.
Operating Cash Flow Ratio:
This ratio assesses a company’s capacity to create cash flow from operations. It is determined by dividing the operating cash flow by current liabilities. A more excellent operating cash flow ratio implies that the firm generates enough cash to meet its short-term obligations.
These different financial ratios can give lenders more insight into a company’s financial position and creditworthiness. However, it is essential to use a combination of ratios and other factors to make informed credit decisions.
Dr. Utkarsh Amaravat is a banker with vast experience in retail credit. He holds a B.E. Mechanical and MBA Marketing degree from Gujarat Technological University and a Ph.D. in management (Credit Risk Management) from Sardar Patel University. He has mainly experience in sales and processing of credit proposals. Sales/Marketing, Relationship Management, Credit, and Risk Management, including research work are vital domains for him.