Financial ratios

economic-dictionary

Financial ratios, also called financial ratios, are ratios that allow comparing the financial situation of the company with optimal values ​​or averages for the sector.

Therefore, they are no more than a fraction in which the numerator and denominator are accounting items obtained from the annual accounts. In addition, they are not only studied in the current year (compared with the sector), it is also convenient to observe the evolution over time.

They are normally calculated for three or five years and making a graph helps interpretation.

The most relevant financial ratios

While it is true that each company is a world and there are many financial ratios, we are going to show the most relevant ones. In each of them we offer a link to the article that develops them in detail and includes the calculation formula and optimal values.

To interpret the ratios we must take into account some questions of a mathematical nature. The lower the numerator, without modifying the denominator, the lower the ratio and vice versa if we focus on the denominator. Also, if that numerator is greater than the denominator, the value will always be greater than one and if it is less, it will be less than one. To convert the values ​​into percentages we multiply by one hundred.

  • Total asset debt ratio ratio. This is perhaps one of the most important, since it shows the ratio of debts to total assets. Although there is an optimal range of values ​​(it can be seen in the detailed article), this will also depend on the activity of the company. For example, in banks this ratio is usually very high. This ratio is sometimes included within those related to solvency.
  • Solvency ratios. In a simple way, it reflects the ability of the company to face its debts with its assets and collection rights. In turn, solvency can be short-term or long-term. The three most relevant ratios in this case are the leverage ratio and the long-term debt and debt ratios (not to be confused with the previous one). Your ideal value will depend on the industry average.
  • Liquidity ratios. In this case, what they measure is the ability to pay your short-term or more immediate debts. In turn, they are classified into liquidity ratio, acid test and cash or treasury ratio. This is explained in detail in the link above.
  • Working capital. It is the difference between the current assets of the company and the short-term debts. Its value must be greater than one. It is convenient to have a cushion for incidents (excess of current assets over short-term liabilities). It would be another form of liquidity measurement and is related to the current ratio ratio (see link to liquidity times). In fact this is a subtraction and the liquidity a quotient.

There are a few more, because you can actually create as many key figures as you need. The truth is that in the financial aspect everything will revolve around the concepts seen, indebtedness, solvency and liquidity. In addition, the most relevant thing is to understand how they are interpreted, as we have explained previously.

Differences with economic ratios

Although they are sometimes considered similar, the truth is that there are differences between the two types of ratios. First of all the financiers deal with financial aspects. Its main data source is the company's balance sheet. As we have seen, they are primarily concerned with debt, solvency and liquidity. These are relevant information for long-term decision making.

The economic ones focus on the aspects related to the activity. They are normally fed by the income statement. On the other hand, they focus on the production cycle, which is normally a calendar year. Some examples of economic ratios are the average periods of supplier or customer turnover, economic or financial profitability. These, unlike financial ratios, are short-term.

Example of financial ratios

Imagine a fictitious company with a balance sheet like the one shown. We have calculated a large part of the ratios seen. We can observe each of the values ​​and compare them with the average of the sector (fictitious) in year x and in turn, observe the evolution of the three years. We do without the graph in this example.

In relation to the ratio of debt to assets, in year X the company is above the sector. That is, their debts represent a smaller proportion of their assets than those of others. In relation to the debt ratio and its two long and short-term variants, it is above the sector. Therefore, the company has a higher external debt in relation to its net worth than the rest.

Regarding liquidity ratios, it is below the sector, except for working capital. If we look at it in greater detail, the one that is closest to the average is the cash test, the acid test being the most distant. You should keep an eye on this aspect, because liquidity is important to deal with payments.

Regarding the evolution, we can highlight that the debt over assets and solvency have increased over time. Those of liquidity, however, have decreased. That the former increase means a greater external debt on their own. That the values ​​of the seconds decrease means a decrease in liquidity. We invite readers to contribute their own interpretations of these financial ratios.

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