Financial Ratios: Definition, Types, Benefits, and Calculations

Financial ratios are one of the important indicators used by a company or institution to assess business performance through financial data.

In addition to measuring the soundness or not of a company's finances, financial ratios are often used as a reference in making decisions and evaluating existing performance. In addition, financial ratios are also one of the important data that is taken into account by both investors and potential investors.

For more details regarding what financial ratios are, let's see more in the following description.

1. What are Financial Ratios?

Financial ratios are a financial analysis tool that can be used as a benchmark or parameter in assessing a company's performance, particularly in the efficient use of resources and financial management. Financial ratios are calculated through several important components in the financial statements, such as profit and loss, cash flow, balance sheet, and so on.

In addition to being a benchmark in assessing the performance of a company or business, financial ratios, also known as financial ratios, are often used as supporting data in decision-making. With this data management can predict the right steps and if they occur in the future.

2. Types of Financial Ratios and Their Calculation Formulas

The following are several types of financial ratios that are commonly used for financial analysis.

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2.1. Liquidity Ratio

The liquidity ratio is a type of ratio used to measure a company's ability to meet short-term financial obligations.

Liquidity ratios are divided into 3 types. Among others, namely:

• Rasio Lancar (Current Ratio

The ratio compares current assets with current liabilities or short-term liabilities.

Current Ratio = Current Assets / Current Liabilities X 100%

• Quick Ratio

The ratio calculates the company's ability to meet short-term obligations without relying on inventory.

Quick Ratio / Quick Ratio / Acid Test Ratio = Cash + Securities + Receivables / Current Debt X 100%

• Cash Ratio

Financial ratios measure a company's ability to pay short-term liabilities with its cash.

Cash ratio / cash ratio = cash + securities / current debt

2.2. Profitability Ratio / Profit Ratio

Profitability ratios measure a company's ability to generate profits from its operational activities. Some of the commonly used profitability ratios include:

• Gross Profit Margin

A ratio that calculates gross profit as a percentage of sales.

Gross Profit Ratio / Gross Profit Margin = NET Sales – COGS / NET Sales X 100%

• Net Profit Margin

A ratio that calculates net profit as a percentage of sales.

Net Profit Ratio / Net Profit Margin = EAT (Earning After Tax) / Net Sales X 100%

• Operating Income Ratio

The ratio formula is used to calculate operating profit income before interest and taxes from sales.

Net Profit / Operating Income Ratio = NET Sales – HPP – (EBIT) / NET Sales X 100%

EBIT is earnings before interest and taxes or income before interest and taxes.

• Return on Equity

The ratio that calculates net profit as a percentage of equity or in other words measures the company's ability to earn net income based on existing equity.

Return on Equity formula = EAT / Total Equity X 100%

• Return on Investment (ROI)

The ratio calculates the amount of profit that the company has managed to get to cover the investment costs that have been incurred.

Return on Investment = EAT / Total Assets X 100%

• Return on Net Worth

The financial ratios used to measure the profit that was successfully generated for shareholder income from the capital itself used.

Return on Net Worth Formula = EAT / Total Equity X 100%

2.3. Solvability Ratio

The solvency ratio measures a company's ability to meet its long-term financial obligations. Several solvency ratios that are commonly used include:

• Debt to Equity Ratio

A ratio that compares total debt to equity.

Debt to Equity Ratio / Debt to Equity Ratio = Total Liabilities / Shareholders' Equity

• Debt To Asset Ratio

The ratio measures the company's total assets financed by creditors. If this ratio is high, it can be said that the company has financial weaknesses where they tend to depend on debt.

Debt to Assets = Total Liabilities / Total Assets

2.4. Activity Ratio

The activity ratio measures the efficiency of a company in using its operational resources. Some commonly used activity ratios include:

• Accounts Receivable Turnover

The ratio measures the number of times the company's receivables rotate in one year.

Accounts Receivable Turnover = Sales / Average Receivables X 100%

• Inventory Turnover Ratio

The ratio measures the number of times a company's inventory rotates in one year.

Inventory Turnover = Sales / Inventory X 100%

• Fixed Asset Turnover

Financial ratios measure and evaluate the company's performance in utilizing fixed assets to increase sales. If the existing value is greater then the existing management is more effective.

Fixed Asset Turnover = Sales / Fixed Assets X 100%

• Total Asset Turnover

This one ratio measures the company's effectiveness in utilizing all assets against sales generated. The bigger the number generated, the better.

Total Asset Turnover = Sales / Total Assets X 100%

• Average Collection Turnover

The ratio is used to measure the length of time it takes for companies to receive bills from consumers in one year.

Average Collection Turnover  = Receivables X 365 / Sales X 100%

• Working Capital Turnover

The ratio is used to measure the level of net working capital turnover by comparing current assets with current liabilities to sales during one period.

Working Capital Turnover = Sales / (Current Assets - Current Liabilities) X 100%

3. Benefits of Financial Ratios

There are a series of benefits contained in financial ratios. What are these benefits? Here are some of the existing benefits

3.1. Measuring Financial Performance

Financial ratios provide a clear picture of a company's financial performance, including those relating to profit, liquidity, solvency, and operational efficiency.

By evaluating financial ratios from time to time, management and investors can identify problems that may arise and have the potential to affect the company's financial health.

3.2. Determining the Ability to Pay Debt

One type of financial ratio, such as the solvency ratio, provides information about a company's ability to pay long-term obligations, one of which is, of course, debt. By looking at this ratio, company management and investors can see the existing financial risks.

3.3. Comparing Company Performance with Competitors

Furthermore, financial ratios function as a company comparison with one another or competitors in the same field.

That way, investors or analysts can compare how a company's performance is financially, whether it is classified as positive or vice versa.

3.4. As Material for Evaluation and Decision Making

The data presented in financial ratios can assist management in making business decisions and evaluating company performance. In this way, the management can make decisions for the next steps that are useful for the sustainability of the company.

3.5. Helps Predict Future Performance

Through the existence of financial ratios, the management and investors will greatly benefit. Because they can easily predict the company's future performance from the various data presented. This can help investors and potential investors to make better investment decisions and minimize financial risk.

3.6. Bridging Corporate Communications with Stakeholders

As with financial reports, the existence of financial ratios is crucial in bridging existing communications between companies and stakeholders such as investors, the government, and other parties regarding the performance of a business.

In addition, through the presence of financial ratios, a business is very likely to obtain funding more easily. This is because the performance of existing companies is exposed very clearly.

4. Financial Ratio Analysis Method

The last discussion is about the method of financial ratio analysis (Financial Ratio Analysis). Reporting from various sources, this one method is divided into 2 general methods. The first is common size analysis. Second, time series and forecasting.

4.1. Common Size Analysis

The common size analysis method works by comparing changes in various items with total assets, liabilities, and sales. The comparison is then presented as a percentage for each component in the financial statements, including the balance sheet and income statement.

Through this method of analysis, a company can obtain information about the relativity of current assets to fixed assets and the company's relativity to capital (capital structure).

Common size analysis can be used to compare financial reports from one period to another, as well as to compare the company's performance with competitors.

4.2. Time Series Analysis and Forecasting

As the name implies, this analytical method is used to predict future financial conditions by comparing financial data over a certain period.

There are several important points that need to be taken into account in this analysis where these points can have an impact on changes in the financial structure. Among other things, namely government regulations, technological changes, shifts in competition, and so on.

BFI friends, that was an explanation of financial ratios. Starting or running a business requires strong determination and a mature strategy. One of the important things in the sustainability of a business is venture capital.

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