What is a Financial Ratio?

A financial ratio is used to calculate a company’s financial status or production against other firms. It is a tool used by investors to analyse and gain information about the finance of a company’s history or the entire business sector. To calculate financial ration, numbers are taken from the balance sheet, income statement, and cash flow statement. The financial ratio is not a calculation but an explanation of the economic status of a company, in terms of profit, liquidity, leverage, and market valuation. A ratio may serve as an indicator, red flag or clue for various issues.

Uses of Financial Ratio:

The financial ratio can be used in two different forms:

  • Analyse firm performance: This performance is evaluated with trend analysis, calculating an individual’s ration on a per-term basis and tracing its worth over time. This analysis is used to find out the source for pending receivables, its average collection time, and a decrease in organisation liquidity status.
  • Relative performance comparison: Here, the comparison is between a company’s profits with the other competitors.

Types of Financial Ratio:

Financial Ratios can be classified into 5 types. Namely:

1. Asset turnover ratios: This ratio is used as a guide to optimize the firm’s assets, inventory, and accounts receivable collection on a regular basis. The two common assets are:

  • Inventory turnover
  • Receivable turnover

2. Dividend turnover ratio: This ratio helps in foresee the company’s future growth. They also give an insight into the company’s dividend policy. The two common dividends are:

  • Payout ratio
  • Dividend Yield

3. Financial leverage ratio: This ratio gives an idea about the company’s long term debt. Two financial leverage ration are:

  • Debt ratio
  • Debt -to-equity-ratio

4. Liquidity Ratio: It gives an understanding of the company’s short term financial obligation.

5. Profitable Ratio: This helps the company to understand how a company is successful in generating profits. Three common profitable are:

  • Return on equity
  • Return on asset
  • Gross profit margin

The above mentioned is the concept, that is elucidated in detail about ‘What is the Financial Ratio?’ for the Commerce students. To know more, stay tuned to BYJU’S.

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