Financial Ratios (Explanation Part 1)

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Author:
Harold Averkamp, CPA, MBA

Financial Ratios Using Cash Flow Statement Amounts, Other Financial Ratios, Benefits and Limitations of Financial Ratios, Vertical Analysis, Horizontal Analysis

Introduction to Financial Ratios

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Financial ratios relate or connect two amounts from a company’s financial statements (balance sheet, income statement, statement of cash flows, etc.). The purpose of financial ratios is to enhance one’s understanding of a company’s operations, use of debt, etc.

The use of financial ratios is also referred to as financial ratio analysis or ratio analysis. That along with vertical analysis and horizontal analysis (all of which we discuss) are part of what is known as financial statement analysis.

Benefit of Financial Ratios

A significant benefit of calculating a company’s financial ratios is being able to make comparisons with the following:

• The averages for the industry in which the company operates
• The ratios of another company in its industry
• Its own ratios from previous years
• Its planned ratios for the current and future years

The comparisons may direct attention to areas within a company that need improvement or where competitors are more successful.

Limitations of Financial Ratios

Some of the limitations of financial ratios are:

• They are based on just a few amounts taken from the financial statements from a previous year. Current and future years could be different due to innovations, economic conditions, global competitors, etc.
• The comparison is useful only with companies in the same industry. This becomes difficult when other companies operate in several industries and their financial statements report only consolidated amounts.
• Companies may apply accounting principles differently. For instance, some U.S. companies use LIFO to assign costs to its inventory and cost of goods sold, while some use FIFO. Some companies will be more conservative when estimating the useful life of equipment, when recording an expenditure as an expense rather than as an asset, and more.
• Since financial statements reflect the historical cost principle, some of a company’s most valuable assets (trade names, logos, unique reputation, etc. that were developed internally) are not reported on the company’s balance sheet.
• They provide a minuscule amount of information compared to the information included in the five main financial statements and the publicly traded corporation’s annual report to the U.S. Securities and Exchange Commission (SEC Form 10-K).

Our Discussion of 15 Financial Ratios

Our explanation will involve the following 15 common financial ratios:

Part 2: Financial ratios using balance sheet amounts

• Ratio #1 Working capital
• Ratio #2 Current ratio
• Ratio #3 Quick (acid test) ratio
• Ratio #4 Debt to equity ratio
• Ratio #5 Debt to total assets

Part 3: Financial ratios using income statement amounts

• Ratio #6 Gross margin (gross profit percentage)
• Ratio #7 Profit margin
• Ratio #8 Earnings per share
• Ratio #9 Times interest earned (interest coverage ratio)

Part 4: Financial ratios using amounts from the balance sheet and the income statement

• Ratio #10 Receivables turnover ratio
• Ratio #11 Days’ sales in receivables (average collection period)
• Ratio #12 Inventory turnover ratio
• Ratio #13 Days’ sales in inventory (days to sell)
• Ratio #14 Return on stockholders’ equity

Part 5: Financial ratios using cash flow statement amounts

• Ratio #15 Free cash flow

Part 5 also includes a discussion of vertical analysis (resulting in common-size income statements and balance sheets) and horizontal analysis (resulting in comparative financial statements and trends over longer time periods).

Part 6 will give you practice examples (with solutions) so you can test yourself to see if you understand what you have learned. Calculating the 15 financial ratios and reviewing your answers will improve your understanding and retention.

NOTE: If you want to learn more about financial statements, click any of the topics below:

• Financial Statements
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Working Capital and Liquidity

Please let us know how we can improve this explanation

A type of financial analysis involving income statements and balance sheets. All income statement amounts are divided by the amount of net sales so that the income statement figures will become percentages of net sales. All balance sheet amounts are divided by total assets so that the balance sheet figures will become percentages of total assets.

One component of financial statement analysis. This method involves financial statements reporting amounts for several years. The earliest year presented is designated as the base year and the subsequent years are expressed as a percentage of the base year amounts. This allows the analyst to more easily see the trend as all amounts are now a percentage of the base year amounts.

A cost flow assumption where the last (recent) costs are assumed to flow out of the asset account first. This means the first (oldest) costs remain on hand. To learn more, see Explanation of Inventory and Cost of Goods Sold.

A cost flow assumption where the first (oldest) costs are assumed to flow out first. This means the latest (recent) costs remain on hand. To learn more, see Explanation of Inventory and Cost of Goods Sold.

The original cost incurred to acquire an asset (as opposed to replacement cost, current cost, or cost adjusted by a general price index). If a company purchased land in 1980 for $10,000 and continues to hold that land, the company’s balance sheet in the year 2024 will report the land at $10,000 (even if the land is now worth $400,000).