How to Calculate Financial Ratios (With Examples)

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Financial Ratios 

Part 1 

Financial ratios are an essential tool for explaining financial statements. All financial reporting activities aim to provide stakeholders such as investors, lenders, shareholders, and regulators with crucial financial performance information (Rist & Pizzica, 2014). Financial ratios compare entries in financial statements to provide detailed information about a company's performance in critical areas such as profitability, liquidity, solvency, and efficiency in management (Henry et al., 2012). Financial ratios can expose otherwise hidden realities about financial performance. 

Financial ratios are an essential tool for forecasting a company's future performance. Ratios are broadly categorized to evaluate liquidity, management efficiency, and stock performance in the market and solvency (Rist & Pizzica, 2014). Historical trends of the financial ratios provide essential information about possibilities in the future. If a company's solvency ratios keep declining over time, the trend may suggest possible liquidation due because of an inability to pay the long-term debt. Similarly, favorable current market ratio trends indicate an enhanced ability to generated income for shareholders and undervalued stock and suggest a possible increase in demand for the stock and subsequent increase in stock price. 

Financial ratios are key indicators used in determining lending terms. Lenders seek to optimize their interests by ensuring that borrowers can repay in due time. As a result, lenders pay attention to specific organizational ratios before deciding on a company's creditworthiness and associated risks (Rist & Pizzica, 2014). Businesses with favorable financial ratios are inclined to obtain more debt financing, better repayment terms, and lower interest rates because of the reduced risk of default (Henry et al., 2012). Therefore, high liquidity, solvency, profitability, efficiency management, and market ratios are enhanced debt financing eligibility. Lenders sometimes make demands regarding the level of solvency and liquidity that borrowers should maintain. 

In academics, financial ratios are used in modeling. Examples of mostly utilized models are Altman Z-score and Beneish M-Score. Altman Z-Score forecasts the likelihood that a business liquidates within the next two years, while the M-score project the likelihood that the management may manipulate financial statements (Zaarour, 2017) . Different combinations of ratios in multiple models provide an opportunity to analyze specific performance areas of a business. 

The ability of financial ratios to explain the contents of financial statements is the most essential. Liquidity, solvency, efficiency, and stock performance are difficult to evaluate by observing financial statements. However, the comparison of various entries using ratios provides actionable information to stakeholders and the company's management (Henry et al., 2012). The use of financial ratios, therefore, guide decision-making processes for both the management and various stakeholders. 

Part 2 

Current Ratio 

The current ratio measures a business' ability to repay debts that are due within 12 months. The ratio is calculated by dividing current assets by the current liabilities (Henry et al., 2012) . A current ratio above 1 means that a business can repay all the debts due within one year using the available current assets. 

Quick Ratio 

The quick ratio measures a company's ability to repay debts within 12 months without the need to sell inventory. The ratio is calculated by dividing current assets less inventory by the total financial obligations due within 12 months (Henry et al., 2012). A quick ratio of above 1 means that a company would repay all the current debts before selling inventory. 

Accounts Receivable Turnover 

Receivable turnover measures a company's ability to collect the owed funds from consumers. The ratio is the revenue made through sales on credit to accounts receivable (Henry et al., 2012). Higher receivable turnover means that the proportion of receivables is lower relative to total sales and, therefore, more efficient in the repayment of debts. 

Accounts Payable Turnover 

Accounts payable turnover estimates the speed at which a business settles debt owed to the suppliers. The ratio is calculated by dividing the total costs owed to the suppliers by the average accounts payable (Rist & Pizzica, 2014). The total owed to suppliers is equal to the cost of goods. Higher accounts payable turnover means that a business pays suppliers more frequently and is therefore eligible for credit. 

Return on Equity 

Return on equity estimates the returns generated for the stockholders. The ratio is calculated by dividing the net income by the owners' equity (Henry et al., 2012). A higher return on equity means that a company is sustainable as it creates more income for shareholders using equity financing. 

Return on Assets 

Return on assets measures a company's effectiveness in utilizing the available assets to create wealth. The ratio is calculated by dividing the net income by the value of assets available (Rist & Pizzica, 2014). A higher return on assets means that a company generates more net income using reduced assets. 

Operating Profit Margin 

The operating profit margin is the proportion of operating income relative to the total sales. The ratio measures each dollar's proportion made through sales left after paying for all variable costs but before paying taxes and interest (Henry et al., 2012). A higher operating profit margin means that a company uses a reduced proportion of sales to pay for costs. 

Net Profit Margin 

Net profit margin measures the proportion of sales left after paying for all costs, interest, and tax. The ratio is calculated by dividing the net income by total sales (Rist & Pizzica, 2014). Therefore, a higher net income profit margin means that a business retains a higher proportion of sales after paying for all costs, interest, and tax. 

Earnings per Share (EPS) 

The EPS of a company estimates the amount of wealth that is generated for shareholders. EPS is the net income ratio to the total outstanding shares (Rist & Pizzica, 2014). A higher EPS means that a business generates more wealth for the stock holders. 

Price to Earnings Ratio 

The P/E ratio of a company estimates whether a stock is valued more or less relative to the actual financial performance. P/E ratio is the proportion of stock market price relative to the income generated for every stock (Rist & Pizzica, 2014). Higher P/E ratio means that shareholders have to pay more to receive a unit dollar of the company's business and is less preferable. 

Part 3 

Liquidity

Table 1 : Liquidity Ratios 

Liquidity Ratios
Period Ending	31-Jan-15	31-Jan-14	Trend
Current ratio ( Total current assets/ Total current liabilities)	0.969	0.882	Positive
Quick Ratio ( Total current assets -Inventory)/ Total current liabilities)	0.278	0.235	Negative

Liquidity ratio estimates the ease with which a business can settle short term debts using assets that can be easily converted to cash. The current ratio of improved in 2015 meaning that the business would repay 96.9% of short term debt using liquid assets as compared to the 88.2% of short term debts in 2014 (Table 1 ). The quick ratio also improved in 2015 meaning that a business would repay 23.5% of short term debt without selling inventory as compared to the 23.5% in 2014. 

Turnover Ratios

Table 2 : Turnover Ratios 

Turnover Ratios
Period Ending	31-Jan-15	31-Jan-14	Trend
Receivable Turnover Ratio as a multiple (Net Credit Sales / Average Accounts Receivable)	71.65	71.33	Positive
Accounts Payable Turnover as a multiple (Cost of Goods sold/accounts payable)	54.58	29.64	Positive

Turnover ratios measures the efficiency of a company's activities in collecting credit from consumers and paying for supplies. The receivable turnover improved slightly in 2015 meaning that the company increased the efficiency of collecting credit from consumers (Table 2). Similarly the accounts payable turnover improved significantly meaning that the company paid suppliers more frequently in 2015 relative to 2014. 

Profitability Ratios 

Table 3 : Profitability Ratios 

Profitability ratios
Period Ending	31-Jan-15	31-Jan-14	Trend
Return on Common Equity (Net Income/Common equity)	20.38%	20.98%	Negative
Return on Assets as a percent (Net Income/Total Assets)	8.14%	7.97%	Positive
Operating Profit Margin as a percent (Operating Profit/ Total sales)	5.59%	5.64%	Negative
Net Profit (after tax) Margin (Net Profit/Total Sales)	3.416%	3.425%	Negative

Profitability estimate a company's ability to generate income relative to other financial metrics such as costs, owners' equity and assets. The return on equity decline in 2015 implying that the company's ability to generate income using the shareholder's equity dropped (Table 3). The return on assets improved slightly implying increased efficiency in utilizing assets to generate income (Table 3). The operating profit margin and net profit margin also decline implying that the costs increased relative to the sales (Table 3). 

Market Ratios 

Market Ratios
Period Ending	31-Jan-15	31-Jan-14	Trend
Earnings per Share as a dollar value((Net Profit -Dividend to preferred stocks)/ Total outstanding stocks)	1.18	1.17	Positive
Price/Earning ratio (Stock Price/Earning per Share)	8.44	7.72	Negative

Market ratios evaluate the pricing of a stock in the market to determine whether a share in undervalued or not. The EPS of the company increased slightly implying that the company generated more income for shareholders (Table 4). The P/E ratio however deteriorated meaning that investors would have to pay more to receive a unit dollar of the company's earnings (Table 4). 

References 

Zaarour, B. D. I. (2017). Financial Statements Earnings Manipulation Detection Using a Layer of Machine Learning. International Journal of Innovation, Management and Technology, 8(3). 

Henry, E., Robinson, T. R., & Van Greuning, J. H. (2012). Financial analysis techniques. Financial reporting & analysis, 327-385. 

Rist, M., & Pizzica, A. J. (2014). Financial ratios for executives: How to assess company strength, fix problems, and make better decisions. Apress.