What Are Financial Ratios and How Are They Used in Business?
Did you know there are over thirteen million different companies in the United States? It’s hard to imagine tracking the performance of many different entities. So exactly how is it done?
Simple: through the use of financial ratios from their financial statements. These ratios help analysts and investors make decisions about the company’s future.
If you want to learn more about the different types of financial ratios, then you’re in the right place. Let’s get started!
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What Are Financial Ratios?
A financial ratio is a set of values taken from a company’s financial statement. The numbers taken from these ratios are used to measure a variety of things.
This includes a company’s profitability, liquidity, leverage, efficiency, and market valuation. At the end of the day, financial ratios are used for the sake of comparison. But who needs these comparisons? Let’s find out.
What Are They Used For?
Financial ratios can either be used internally by the company or externally by other parties. When used internally it is mainly to track performance. When done correctly, this type of internal tracking can help savvy companies spot trends that it can adapt to.
However, more commonly, financial ratios are used by external analysts and investors who want to know more about the company’s financial performance.
They do this by comparing the company’s financial ratio to the industry average. That way, they can get a good idea of whether the company is performing better or worse than its competition.
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How Can You Calculate Financial Ratios?
There are many different financial ratios you can measure, all of which are grouped into different types of categories. These categories include:
- Profitability ratios
- Liquidity ratios
- Market value ratios
- Efficiency ratios
- Leverage ratios
Each of these categories has numerous financial ratios filed under it. So how do you calculate them? By putting the numbers into the correct formula. To save time, we’ll give you the equations to find the top three most popular financial ratios used.
These are the ROI ratio (return on investment), ROA ratio (return on assets), and debt-to-equity ratio. To find the return on investment, simply divide the net income of the company by the owner equity.
To find a return on assets, divide the net income by the total number of assets. To find the debt-to-equity ratio divide the company’s total liabilities by the combined shareholder’s equity.
Plug these numbers into the equivalent ratio calculator found here and you have your financial ratio!
Did You Enjoy This Article? Keep Exploring to Learn More
We hope this article helped you learn more about financial ratios and why they’re important for understanding a business. These ratios are the key to understanding what decisions increase business, and which ones don’t.
As such, anyone who wants to speculate about a business’s future needs to be able to understand financial ratios.
If you want more business-related articles like this one, then you’re in the right place. Keep on reading to find other topics that you’re sure to love.