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Financial statements contain a lot of data, each signalling a different aspect of a business. Financial ratios standardise these statements into clear signals that show how a business performs, manages risk, and creates value. Whether you are an investor, a bank, or a business owner, knowing what financial ratios are helps turn raw financial figures into actionable insights.
Also referred to as accounting ratios, financial ratios are used to calculate the performance of a firm based on its financial reports or statements. Financial ratios help in comparing a company with other companies to understand how well it meets debt obligations, generates profits and uses its resources effectively.
Investors conduct financial ratio analysis to review a company’s financial health by evaluating its past and current financial statements. Analysts select ratios that are relevant to their goal, such as liquidity or profitability.
These ratios help in converting data such as income statements, balance sheets, and cash flow statements and interpret them into meaningful insights.
The calculated ratio is used to compare against the company’s past performance and to analyse it against the industry's benchmark.
Financial ratio analysis gives investors a comprehensive view of a company’s strengths and weaknesses.
Investors use different types of financial ratios with a primary focus on performance, financial health, and efficiency. The five primary categories are:
To understand how financial ratios can help you in analysing a company’s financial position. Here are some instances where financial ratios are used.
If a company asset is INR 2,00,000 and current liabilities are INR 1,00,000. The current ratio would be 2:1, which indicates that the company has twice the amount of short-term assets needed to cover its short-term obligations, suggesting comfortable liquidity.
If total debt is INR 5,00,000 and shareholders’ equity is INR 10,00,000, the debt-to-equity ratio is 0.5. A lower ratio indicates lower reliance on borrowed funds, which generally signals lower long-term financial risk.
If a company earns a net profit of INR 2,00,000 on revenue of INR 20,00,000. The net profit margin is 10 per cent. This means the company retains INR 10 as profit for every INR 100 earned, reflecting cost control and pricing efficiency.
If the cost of goods sold is INR 12,00,000 and the average inventory is INR 3,00,000, the inventory turnover is 4 times. This means the company sells and replaces its inventory four times during the period, indicating effective inventory management.
If a company’s share price is INR 200 and its earnings per share are INR 20, the P/E ratio is 10. A P/E ratio of 10 suggests that investors are willing to pay INR 10 for every INR 1 of earnings, reflecting market expectations about growth and risk.
Financial ratios are comparisons between two or more items from a company’s financial statements. They are primarily used to evaluate a firm’s liquidity, profitability, solvency, and operational efficiency:
Using financial statement analysis ratios helps in reducing the decision time for investors, as it standardises financial statements into metrics that can then be compared to other companies’ financial performance. Some of the important financial ratios formulas are:
Ratios
Formula
Category
Current Ratio
Current Assets/ Current Liabilities
Liquidity
Quick Ratio
(Current Assets – Inventory)/ Current Liabilities
Debt-Equity Ratio
Total Debt/ Total Equity
Solvency
Net Profit Margin
(Net Profit/Revenue) x 100
Profitability
Return on Equity (ROE)
(Net Income/ Shareholders’ Equity) x 100
It’s important to understand how financial ratios function and apply to the raw financial data so you can understand business performance accurately, assess any financial risk present, and make informed decisions.
Ratio analysis in financial management helps interpret how profitable and efficient a company is. You can compare the ratio with past results or with other companies in a similar sector.
Financial ratio analysis shows how a company covers its short-term bills and manages long-term debt. Banks use these numbers to determine whether to give loans and assess the risk in terms of liquidity, credit, solvency and operations.
Financial ratios are used by investors, managers, lenders, and analysts to assess performance, financial stability, and business decisions. Each group applies ratios based on their objectives:
By using financial ratios, you can streamline the data and information of a company in a way that makes it easier to understand how it is performing against other companies and its own goals. Each ratio serves a distinct purpose and is used by different entities to focus on certain aspects of a business’s performance. Investors looking to effectively manage their wealth and investments can choose to open a premium savings account with DBS Treasures.
Disclaimer: The information provided in this article is for general informational purposes only. For specific guidance or details, please consult with your Relationship Manager or a relevant expert.
