The Importance of Calculating Ratios in Finance
Financial ratios are calculated using numerical numbers extracted from financial statements - the balance sheet, income statement, and cash flow statement – in order to obtain useful information when analyzing a company’s financial performance.
The most common ratios used to gain meaningful information about a company and measure its financial health are current ratios, quick ratios, Leverage, DSCR, days receivables, days inventory, days payable, cash cycle.
The main two purposes of Financial Ratio Analysis are:
- Monitoring and Analyzing company performance by determining financial ratios per period and tracking the change in their values over time.
- Comparing the company's financial performance with competitors to determine whether the company is doing well or not.
Ratios are useful at identifying trends in the business and providing warning signs when it may be time to make a change.
The Most Common Ratios in Finance
1- Current Ratio
Current Ratio measures a company’s ability to pay off short-term liabilities with current assets.
Current ratio = Current assets / Current liabilities
2- Quick Ratio
The Quick Ratio, also known as the acid-test measures a company’s ability to pay off short-term liabilities with quick assets. (Assets that are converted into cash easily).
Leverage ratios are used to evaluate a company’s debt levels.
Below are 5 of the most commonly used leverage ratios:
- Debt-to-Assets Ratio = Total Debt / Total Assets
- Debt-to-Equity Ratio = Total Debt / Total Equity
- Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)
- Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
- Asset-to-Equity Ratio = Total Assets / Total Equity
The debt service coverage ratio shows how readily a firm can pay its current debt obligations:
DSCR= Net Operating Income / Total Debt Service (principal amount + interest on a loan).
5- Days Receivables
Days Receivables Outstanding is how long you take to clear your accounts receivable. In other words, it's the number of days that an invoice will remain outstanding before it's collected.
Days Receivable Outstanding (DRO) = (Accounts Receivable / Revenue) x 365
6- Days Inventory
Days inventory also known as (Inventory Days of Supply, Days Inventory Outstanding or the Inventory Period) is the average number of days the company holds its inventory before selling it to customers.
Days Inventory Outstanding (DIO) = (Average Inventory / Cost of Goods Sold) x 365
7- Days Payable
Days payable outstanding is the average number of days it takes a company to pay back its accounts payable. Therefore, DPO measures how well a company is managing its accounts payable.
Days Payable Outstanding = (Average Accounts Payable / Cost of Goods Sold) x 365
Cost of Sales = Beginning Inventory + Purchases – Ending Inventory
8- Cash Cycle
The Cash Conversion Cycle (CCC) is the amount of time it takes a company to convert its investments in inventory to cash
Cash Conversion Cycle = DRO + DIO – DPO