Financial ratios. What they are and what types exist

The purpose of the technical analysis of the Financial Statements or Balance Sheet of Accounts is to know the composition of the assets and rights of the company, of its obligations with partners and third parties, and of the economic results of its activity, at a given moment, but also over time.

In this way, it is possible to identify a horizontal analysis of the company's financial statements, which comprises the analysis of a given item over time. The horizontal analysis is a percentage calculation. For example: analyze over 5 years, at the close of each business year, how debts to suppliers have evolved as a percentage.

In addition, there is a vertical or structural analysis of the company's financial statements, which includes the proportion that certain items maintain with respect to the total. For example: to analyze the proportion of assets held in cash with respect to total assets, or the proportion of property, plant and equipment with respect to total assets. These analyses are performed for a single cut-off date, i.e., in a static manner.

Companies, in order to obtain better information, apply financial ratios to observe the behavior of vertical analysis over time, i.e. horizontally.

After these global tests on the company's Financial Statements, ratios are applied, which are relationships between elements of the Financial Statements, established to determine the company's capacity to obtain profitability, to collect and make payments, to face short and long term debts, among other indicators.

What is a Financial Ratio?

Within the ratios mentioned above, there are some specific ratios for analyzing the company's financial operations, i.e., collections and payments.

The financial ratios establish relationships between the different components of the financial statements to determine the company's collection and payment capacity in the short, medium and long term, depending on the relationships established.

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Most important types of Financial Ratios

To analyze the financial ratios, it is necessary to focus specifically on the company's Balance Sheet of Accounts:

Depending on the company's line of business, the financing needs of third parties, the need to provide financing to customers, the importance of having fixed assets, among other factors, the most important financial ratios to analyze are as follows:

Working Capital

Working capital or working capital represents the resources available to the company to meet its short-term payment obligations. 

For the simple calculation of the Working Capital Fund, the Current Assets and Current Liabilities of the Balance Sheet are compared globally, without considering specific items.

Working Capital = Current Assets - Current Liabilities

The ideal result is to have a positive Working Capital Fund, but one that does not generate idle resources. 

To improve the company's Working Capital, it is necessary, for example, to: accelerate the Collection Cycle, balance the Payment Cycle according to the Collection Cycle, refinance Short-Term Debts to Long-Term, efficiently manage Inventory, look for financial alternatives, control the withdrawal of dividends.

If you need more in-depth information on working capital, you can read our article:

• Working capital - What is it and how to calculate it?

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Liquidity Ratio

The company's working capital or current assets represent a measure of the company's short-term liquidity, i.e., it represents cash resources, cash equivalents, short-term investments, short-term receivables, merchandise and other high turnover receivables.

The company needs cash or its equivalent to meet short-term debts; these debts are represented by Current Liabilities. 

Includes: debts with suppliers, tax and social security debts, bank debts due in the short term, sundry creditors. 

Liquidity = Current Assets / Current Liabilities

The liquidity ratio represents the company's ability to meet short-term liabilities. This ratio also measures the company's liquid funds reserve in relation to short-term obligations.

Knowing the liquidity ratio helps the company to plan the acquisition of new debts or the application of funds in short-term investments, for example: placement of time deposits, purchase of foreign currency, among others.

• Liquidity ratio. Interpretation and how to calculate it

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Debt Ratio

The debt ratio is used to diagnose the quantity and quality of the company's debt, as well as to check the extent to which the company is earning enough profit to support its financial burdens.

The total debt ratio can be measured on a short-term or long-term basis, depending on the company's need for information.

Debt = Liabilities / (Liabilities + Equity)

The optimal value of the debt ratio is between 0.4 and 0.6. If it is higher than 0.6, the company is losing autonomy and depending too much on third parties. If it is lower than 0.4, the company may have an excess of equity capital, missing out on external financing opportunities.

• Debt ratio. How to calculate and interpret it

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Solvency Ratio

The process of assessing long-term solvency is different from the assessment of short-term liquidity, both in terms of the time horizon and the basic variables used. While the short-term analysis focuses on liquidity, the long-term analysis focuses on earnings as a fundamental element for the generation of long-term solvency and liquidity.

In general terms, the solvency ratio corresponds to the ratio between the company's total assets and total liabilities, i.e., it measures the company's ability to meet its long-term debts. 

Solvency = Total Assets / Total Liabilities

Ideally, total assets should exceed total liabilities by no more than 2.

Along with the simple solvency formula, the company's property, plant and equipment ratio is also evaluated to assess how many assets that are difficult to convert into cash the company owns. While it is an important backing or guarantee to have real estate and vehicles, for example, it is not possible to convert them into cash or its equivalent immediately.

Fixed Assets = Non-current or fixed assets / Total Assets

Ideally, fixed assets should not exceed 0.5, i.e., fixed assets should not exceed 50% of total assets, but this depends on the line of business, operating needs, among others.

• Solvency Ratio. What it is and how to calculate it

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Leverage Ratio

Financial leverage involves the inclusion in a company's capital structure of debt that pays a fixed return, since no creditor would be willing to lend funds to the company without the cushion and security provided by equity capital, i.e., using the existence of a given amount of equity capital as the basis for borrowing.

The ideal result of the financial leverage is close to 1, which implies that it is indistinct to use own or third party financing.

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• Financial leverage ratio. How it affects companies

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Why are Financial Ratios important for companies?

Financial ratios are useful for efficient and timely decision making by stakeholders, as are the techniques of horizontal and vertical analysis of financial statements.

What indicators are focal for each stakeholder?

• Suppliers: liquidity, solvency and indebtedness.
• Banks: liquidity, solvency, indebtedness, cash flows.
• Investors: liquidity.
• Management: all ratios, including positive cash flow with time balance.

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How to calculate and interpret Financial Ratios?

The calculation of financial ratios requires the following steps:

1. Preliminary stage: consists of gathering and studying all the information necessary to carry out the pertinent analyses, for example: having approved Financial Statements that reflect the economic-financial reality of the company as of a cut-off date, knowing the audit report of said Financial Statements, analyzing the events subsequent to the close of the fiscal year.
2. Application of analysis tools: global percentage studies, comprising vertical or structural analysis and horizontal analysis; and the application of ratios or indexes. In this case, financial ratios, but there are other ratios that provide essential information about the company.
3. Transmission of information: drafting of the report with the interpretation of the ratios, which is necessary for stakeholders to make decisions. The interpretation of the ratios depends specifically on each indicator calculated.
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