Do you know what’s the meaning of financial ratio? In general, financial ratio can be defined as a quantitative analysis of information contained in a company’s financial statements to evaluate aspects of operations and the performance of the company’s financials. The financial ratio is an appropriate action to know and assess the company’s growth before looking at the company’s financial statements. This article will explain the readers about financial ratio and their types.
Functions of Financial Ratio
There are several functions of financial ratio. The financial ratio can quickly detect a company’s potential situation, whether related to improvement or vice versa. Also, a company can analyze the strength of their finances using financial ratio. The level of a company’s assets used can be seen from this. In addition, financial ratio can also help analyze the company’s growth and development in the future.
Types of Financial Ratio and Formula
Speaking about the financial ratio types, Darmawan (2020), in his book entitled ‘Dasar-Dasar Memahami Rasio dan Laporan Keuangan’ or ‘Basics of Understanding Financial Ratios and Statements’ explained that there are several types of financial ratio. Here is an explanation of the types of financial ratio and their formulas:
Profitability ratio can be defined as a ratio that aims to know how the company can generate profit in a certain period, from operations activity such as sales transaction, capital, to the number of company employees. This profitability ratio can provide an overview of the company’s management effectiveness in operations activity.
There are several types of profitability ratio. To begin with, there is Return on Investment (ROI). This ratio provides information about a company’s ability to generate profits based on the company’s asset amount. Here is the formula for calculating Return on Investment (ROI):
Furthermore, there is return on equity. The ratio can calculate the company’s net income after tax by using the company’s capital. Here is the formula to calculate return on equity:
Another one, there is Net Profit Margin (NPM). The ratio is able to calculate the net income that the company earns compared to its sales. Net Profit Margin (NPM) can explain the company’s efficiency level. Here is the formula to calculate Net Profit Margin (NPM):
Then, the last type of profitability ratio is the gross profit margin. The ratio can calculate the efficiency of a company’s production costs control. This can indicate the ability of a company in production efficiency. In other words, the gross profit margin is a percentage of the company’s gross profit by the sales in a period. Here is the formula to calculate gross profit margin:
This ratio can be defined as a parameter that describes a company’s ability to pay all the short-term financial obligations by the due date using the available assets. A company can be said to be liquid if it can pay the obligations. In contrast, a company can be said to be illiquid if it can’t pay the obligations.
There are several types of liquidity ratio. To begin with, there is current ratio. This ratio is a comparison between current assets and current liabilities, which is the most common measure to know the company’s ability to fulfill its short-term obligations. In other words, this ratio can provide information about how current assets can cover up a company’s current liabilities. Here is the formula for calculating the current ratio.
Furthermore, there is quick ratio, or often called the acid test ratio. One of the experts in Indonesia, Raharjaputra, expressed his opinion about the definition of a quick ratio. According to him, a quick ratio is a ratio that used to measure the company’s ability to pay its obligations using current assets that are reduced by the inventory. Also, Raharjaputra considers this as less liquid. Here is the formula to calculating the quick ratio:
Another one, there is cash ratio. This ratio shows the company’s cash position, which can cover the current debt. Here is the formula to calculate the cash ratio:
The last type of liquidity ratio is the cash turnover ratio. This ratio can indicate the relative value of net sales on the net working capital. Here is the formula to calculate the cash turnover ratio:
The solvability ratio provides information about how the company can settle its obligations if the company is liquidated. This ratio relates to the funding decisions that the company will choose to finance in debt rather than personal capital. In other words, the solvability ratio is a ratio that is used to measure how much company assets are funded through debt.
There are several types of solvability ratio. To begin with, there is Debt to Asset Ratio (DAR). This ratio is the total liability to the asset. The ratio able to inform the number of comparisons on total assets and total liabilities. Here is the formula to calculate Debt to Asset Ratio (DAR):
Furthermore, there is Debt to Equity Ratio (DER). This ratio is the proportion of a company’s debt financing relative to its equity. Here is the formula to calculate the Debt to Equity Ratio (DER):
Last but not least, there is Interest Coverage Ratio (IC). This ratio can provide information about how well the company can pay the interest on its outstanding debts. Here is the formula to calculate Interest Coverage Ratio (IC):
This ratio can evaluate a company’s ability to use its assets and liability to generate sales and increase profits. In addition, this ratio can provide the basics of comparison in a certain reporting period to analyze the changes that occur during the time.
There are several types of activity ratio. To begin with, there is accounts receivable turnover ratio. The function of this ratio is to determine the entity’s ability to collect a certain amount of money from the customer. Here is the formula in calculating the accounts receivable turnover ratio:
Furthermore, there is merchandise inventory turnover ratio. This ratio can show the intensity of a company in selling and replacing their inventory in a certain period. Here is the formula to calculate the merchandise inventory turnover ratio:
Last, there is total assets turnover ratio. This ratio is used as a parameter of efficiency level used by a company to maximize revenue by using owned assets. Here is the formula in calculating the total assets turnover ratio:
Financial ratio play an essential role for a company. Therefore, in making a decision or policy, a company will consider carefully by looking at the financial ratio. A company can find out how the company’s future growth and development using financial ratio. In order to give convenience for your company in the financial management, HashMicro provide Accounting Software with top features. Contact us to get the best offer and a free demo.