Financial Ratio term indicates about the performance of the company and allows to perform quantitative analysis to have better knowledge about the company. Benjamin Graham was the father of fundamental analysis. It always compares with the previous year’s performances or with the other companies of same industry (Seegmiller, 2023). So,The financial ratio uses the company’s financial data to analyze. Managers use the ratios analysis to get an idea about the weakness and strengths of the company which helps to improve their strategic plans. So,The financial ratios analysis helps the analysts or the experts of finance to calculate the future profits of the company by the past performances (Bloomenthal, 2024). There are four different types of financial ratios such as profitability ratios, leverage ratios, valuation ratios and operating ratios.
Profitability Ratios
Profitability ratios describe how a company is going to generate profits from its functions. So,It is a type of financial ratio which helps in finding the financial performance of the company profits with regard to the revenue, balance sheets, operating costs, and shareholders’ fairness over a specific time period (Baltova, 2023). The profitability is again divided into six categories such as PAT and PAT margin growth, EBITDA margin, and EBITDA growth, return on equity (ROE), Return on asset (ROA), Return on capital employed (ROCE), and earnings per share (EPS).
PAT and PAT Main Growth
PAT refers to profit after tax which describes how much a company earned after all the income tax deductions. Profit after tax is calculated by subtracting the total profit before tax from the total tax rate. So,Every investor and shareholder look at the profit after tax to analyze the financial state and performance of the company. Profit after tax margin is the state offinancial presentation which calculates the net income of a company and net sales (Astuti, 2021). So,Profit after tax margin is calculated as net income of the company divided by the net sales of that company. This is helpful to the investors to compare one company’s tax margin to other companies in the same industry.
EBITDA & EBITDA Margin
EBITDA means earnings before interest, taxes, depreciation, and Amortization which is used to evaluate the operating performance of the company and mostly dependent on the company’s capital resources. It is calculated as operating profit plus depreciation and amortization. The business owners might benefit from using EBITDA to know the value of their business, which includes operating costs. EBITDA margin describes the earnings before interest, taxes, depreciation, amortization, and the margin define about the capital that is leftover after all the payments except interest, taxes, and other charges. This helps us to compare with other companies in the same industry in accordance with the profitability and accounting rules.
Return On Equity (ROE)
The company’s net income determines the return on equity for the shareholders, based on their equity investment.The net income indicates overall the income of the company, expenses, taxes which a company generates in a certain period. Return on equity describes the percentage of the company how good it is performing and managing the financial allowances from their shareholders. The shareholders’ equity determines the calculation of the company’s net income. The high return on equity indicates that it does not need any more debts and loans, which helps to avoid the interest expenses.
ROE vs ROCE
Return on equity (ROE) and return to capital employed (ROCE) both are important factors of finance but measuring different things. ROE determines how the organization uses shareholders equity to gain profits whereas ROCE measures how a company uses its capital to get the profits. ROE is the consideration of both equity and borrowed capital, but the ROCE considers only equity. The higher ROE indicates effective usage of the equity, and the higher ROCE helps to suggest better management of the overall capital. ROCE is helpful for the companies with higher debt and the ROE works with the organizations with high dependence on equity.
Return on Asset (ROA)
Return on asset describes how the company is successfully generating capital from its resources. The higher percentage of the return on assets indicates that the company is using their resources well and the higher number indicates that the company is generating high profits with less resources. Return on assets is calculates as net income of the company divided by the total resources used. The ROA ratio helps the investors and executives of the company to compare with other companies in the same industry.
Return on Capital Employed (ROCE)
The company reveals the efficiency of its use of capital through the ratio of its profits to the capital employed, which is its return on capital employed. It also indicates the company’s profitability by taking consideration of the overall capital it employes.So,The shareholdersand investors might benefit from the return on capital employed to analyze the purpose of investment. Earnings Before Interest and Tax (EBIT) are used to divide capital employed, calculating the return on capital. So,EBIT is calculated as total assets subtracted from current liabilities.Compared to the other fundamentals like return to equity considers only the profitability of the company’s shareholders but the Return on capital employed helps to include the debt and equity also (Hayes, 2024).
Earnings Per Share (EPS)
Earnings per share describes the net income of the company and how much the shareholders earn per share if a company sells their shares. EPS explains about the current and future profitability of the company. So,This is helpful to understand the financial growth and knowledge of the company. Earnings per sharesare calculated as net profit divided by the number of common outstanding shares of the company.So, It is helpful in comparing several companies’ performances and choosing the suitable investment options that might match the investment goals of a company. The consistency of the earnings per share defines profitability and making company for the good investment.
Leverage Ratios
is defined as one of the financial measurements that focuses on how much capital comes in the form of debt for the company or estimates the capacity of the company that meets its financial responsibilities.Total assets are divided by total equity to calculate the leverage ratio.We use four different ratios: interest coverage, debt-to-equity ratio, debt-to-asset ratio, and financial ratio.The leverage ratio of a company helps the investors to identify the level risk of that is associated with the other company. In some industries, practices may differ.
Interest Coverage Ratio
Interest coverage ratio helps to identify and understand how much the company is earning with respect to the debt burden.The company calculates its interest coverage ratio, which signifies its earnings before interest and taxes ability to cover its interest payments, by dividing EBIT by its interest payments.An extremely low debt indicates the healthy finance state of the company. Total liabilities are calculated based on shareholders’ equity.The higher interest coverage ratio will be beneficial whereas the ideal ratio will vary from one industry to another industry. The interest coverage ratios focus on how fast the company will pay their interest due on the outstanding debt.
Debt to Equity Ratio
It measures the total debt capital with respect to the total equity capital of the company. If the debt-to-equity ratio is equal to one, then it describes that an equal amount of debt and total equity capital (Tyre, 2022). Debt to equity is calculated as the total debt divided by the total equity. The investors are able to modify the debt-to-equity ratio to consider the long-term risks. Debt to equity ratio shows the difference from one industry to another industry,which is good to compare direct competitors of the company. The company is not expanding by taking on less financing debt, which results in a lower debt-to-equity ratio and less risk compared to a higher one.
Debt to Asset Ratio
The debt to asset ratio describes the comparison of the company’s long-term and short-term responsibilities to their total assets. If a company is having high debt to asset ratio, then it is having high debt percentage. The debt to asset ratio helps to show the investors and growth of the business in the time of accounting and preparing financial estimations. Girsch-Bock determines the amount of business funding from company equity and the amount from debt funds. To find the debt-to-asset ratio, we first subtract total liabilities from total assets to determine the net asset position. Then, we divide the net asset position by the total assets. This helps the investors to find out the present and future objectives of the company.
Financial Leverage Ratio
The financial leverage ratio describes the ability of the company to meet its long term and short-term goals and responsibilities. It is the process of getting money from other sources in order to purchase some goods or services that are necessary. The organization calculates its financial leverage ratio by dividing its equity by its total assets.
This ratio helps to increase the possibility of investments from the investors.
References
Astuti, W. (2021). A Literature Review of Net Profit Margin. Social Science Studies, 1(2), 115-128.
Baltova, A. (2023, May 30). Profitability Ratios – Definitions, Types, Formulas. Retrieved from 365 Financial Analyst: https://365financialanalyst.com/knowledge-hub/financial-analysis/profitability-ratios/
Bloomenthal, A. (2024, February 26). Financial Ratio Analysis: Definition, Types, Examples, and How to Use. Retrieved from Investopedia: https://www.investopedia.com/terms/r/ratioanalysis.asp
Girsch-Bock, M. (2024, May 10). A Guide to Calculating and Interpreting Your Debt-to-Asset Ratio. Retrieved from The Ascent: https://www.fool.com/the-ascent/small-business/accounting/debt-to-asset-ratio/
Hayes, A. (2024, June 20). Return on Capital Employed (ROCE): Ratio, Interpretation, and Example. Retrieved from Investopedia: https://www.investopedia.com/terms/r/roce.asp
Seegmiller, T. (2023, February 15). Financial Ratios – What Are They And How Can You Use Them? Retrieved from Vena Solutions: https://www.venasolutions.com/blog/financial-ratios
Tyre, D. (2022, August 3). Debt to Equity Ratio, Demystified. Retrieved from Hubspot: https://blog.hubspot.com/sales/debt-equity-ratio
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