In today’s fast-paced and changing business world, the ability to make accurate and wise financial decisions is critical for companies’ survival and success, and financial ratios are one of the most important tools in a financial analyst’s arsenal. They are not just passing numbers calculated from financial statements; rather, they are keys that open the doors to a deep understanding of companies’ performance and directing their strategies. Whether you are an entrepreneur seeking a better understanding of his company’s financial position or an investor looking to make informed investment decisions, these ratios provide you with the compass you need. So let’s explore how these vital tools can turn financial data into strategic insights and how Qawid accounting software can make this process easier and more accurate.
What are financial ratios?
Financial ratios are a vital and popular tool in financial analysis, used to understand a company’s financial position and make informed decisions based on that understanding. The process of analyzing financial ratios involves comparing two or more elements of financial statements to extract valuable information about a company’s performance. These ratios provide insights that help identify strengths and weaknesses, and predict the sustainability of the company.
What are the different types of financial ratios, and how do you calculate each ratio?
Types of financial ratios include:
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Debt ratios
It expresses the extent to which the company relies on loans to finance its assets, and is an important tool for assessing the extent of the risk associated with financing the company through debt, which may negatively affect its future and financial stability.
Increasing reliance on debt may lead to increased financial burdens due to interest and debt obligations, which exposes the company to the risk of inability to repay. It is important to note that these ratios, which come in various types, are crucial for both owners and lenders.
Debt-to-total-assets ratio
- Calculation method: total debts\total assets.
- Interpretation: It indicates the extent to which debt contributes to financing the company’s assets. If its percentage is high, it means that the company depends on loans.
Debt-to-equity ratio
- Calculation method: total debt/equity.
- Interpretation: It reflects the extent to which the company relies on its own capital in exchange for loans, and the higher this ratio, the greater the company’s risk.
Debt-to-shareholders’ equity ratio
- Calculation method: total debts\Total shareholders’ equity.
- Interpretation: It measures a company’s reliance on debt to finance its assets versus shareholders’ equity. A high ratio means that the company relies more on loans.
Interest coverage ratio
- Calculation method: profits before interest and zakat\total interest expense.
- Interpretation: The ability of the company to pay interest expenses from its operating profits is significant. A high ratio means that the company has the ability to pay interest.
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Market ratios
It is one of the types of financial ratios that are used to evaluate the performance and position of the company from the perspective of the market and investors. It is worth noting that it helps to understand how the market evaluates the company’s shares and its financial performance, and its types include:
Earnings per share ratio
- Calculation method: net profit\average number of common shares traded during the year.
- Interpretation: It expresses the profits achieved by each traded share. A high percentage indicates excellent performance and high profitability per share.
Price-earnings Ratio
- Calculation method: market price per share\earnings per share.
- Interpretation: It measures investors’ willingness to pay a certain price for a stock in exchange for its annual earnings. A high ratio means that investors expect future growth for the company.
Dividends Payout Ratio
- Calculation method: Dividends distributed to shareholders\net profit.
- Interpretation: It reflects the percentage of cash dividends distributed to shareholders out of the total profits achieved.
Return on retention ratio
- calculation method
Market value per share at the end of the period – market value per share at the beginning of the period + dividend per share Market value per share at the beginning of the period.
- Interpretation
It is one of the types of financial ratios that expresses the gains that an investor achieves from holding a stock during a specific financial period, which helps in evaluating the attractiveness of investing in the stock.
Return on investment in shares
- Calculation method: share selling price – share purchase price + share of distributed dividends / share purchase price.
- Interpretation: It measures the return that an investor can get from buying a stock and holding it until selling it, such as dividends.
The ratio of market value to book value
- Calculation method: market price per share\book value per share.
- Interpretation: It is used to evaluate the performance and position of the company from the point of view of investors, as it reflects the extent of appreciation that the market gives to the value of the company.
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Profitability ratios
It is considered one of the most important financial ratios that are used to evaluate the company’s performance in terms of achieving profits from its various activities and projects. It is worth noting that investors and lenders are particularly interested in these ratios because they provide an accurate view of the company’s efficiency in achieving profits and controlling costs and expenses. Among the types of profitability ratios are:
Gross profit ratio
- Calculation method: gross profit\sales.
- Interpretation: It indicates how efficiently the company manages the costs of sales.
Net profit ratio
- Calculation method: net profit/net sales.
- Interpretation: It expresses the profits achieved by the company after deducting all expenses from sales.
Return on assets ratio
- Calculation method: net profit\average assets.
- Interpretation: It measures a company’s ability to generate profits from its assets, and shows how efficiently the company uses its assets to generate profit.
Return on capital
- Calculation method: Net profit\working capital.
- Interpretation: It refers to the profits earned by the company through the use of working capital.
Ratio of return on shareholders’ equity
- Calculation method: Net profit\Average shareholders’ equity.
- Interpretation: It shows the company’s ability to generate profits from the money of investors and shareholders.
Earnings per share ratio
- Calculation method: Net profit/average number of shares traded.
- Interpretation: It measures the profits that a single share can generate, and expresses the attractiveness of the stock to investors in terms of expected returns.
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Activity ratios
It is one of the types of financial ratios that focus on evaluating the company’s efficiency in managing its various resources and assets, and converting them into cash by achieving sales. It is worth noting that it is important for managers and shareholders because it shows the company’s efficiency in using its assets to achieve revenues, and its types include:
Asset turnover rate
- Calculation method: Net sales\Average total assets.
- Interpretation: refers to the company’s ability to generate sales from its assets.
Working capital turnover rate
- Calculation method: Net sales\average working capital.
- Interpretation: It measures a company’s ability to generate sales through efficient use of working capital.
Average credit period
- Calculation method: 365\working capital turnover ratio.
- Interpretation: It expresses the period of time that the company needs to settle the credit period that it grants to its customers.
Receivables turnover rate
- Calculation method: net forward sales/average accounts receivable.
- Interpretation: It refers to the company’s efficiency in collecting accounts receivable and converting them into cash.
Receivables Days
- Calculation method: 365\debtors turnover ratio.
- Interpretation: It expresses the amount of time required by the company to collect accounts receivable.
Inventory turnover rate
Calculation method: cost of goods sold\average inventory.
Interpretation: It measures the number of times a company sells and replenishes inventory during a given period.
Inventory Day Rate
- Calculation method: 365\Inventory turnover ratio.
- Interpretation: It expresses the period of time a company needs to sell all its inventory.
Operational cycle
- Calculation method: Average Inventory days + Average Inventory days.
- Interpretation: It refers to the time period required to complete a complete operating cycle, from purchasing raw materials until collecting cash from sales.
Cash cycle
- Calculation method: Operational cycle – average credit period.
- Interpretation: It expresses the time period required to complete the net cash cycle, from paying suppliers until collecting cash from customers.
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Liquidity ratios
Liquidity ratios are among the basic financial ratios that enable measuring the company’s ability to meet its short-term obligations using its current assets. They also enable investors and lenders to evaluate the company’s financial position and ensure its ability to confront sudden financial crises, of which types:
current ratio
It expresses the company’s ability to pay its current liabilities using its current assets.
- Calculation method: Current assets\Current liabilities.
- Interpretation
A high ratio (> 2:1) indicates that the company is in a strong financial position and is able to meet its obligations easily.
Low (< 1:1) indicates potential financial difficulties in meeting obligations.
Remember that the standard ratio is 2:1, but a ratio that is too high may reflect inefficient use of assets, as the company may be holding too many liquid assets rather than investing them to generate profits.
Cash flow ratio
It expresses a company’s ability to pay its current liabilities using only cash and cash equivalents, excluding debt and inventory.
- Calculation method: cash and cash equivalents/ Current liabilities.
- Interpretation
A high ratio indicates that the company has sufficient cash flow to meet immediate obligations.
The standard ratio is 1:1, meaning cash and cash equivalents equal current liabilities.
A ratio of slightly less than 1:1 may be acceptable, depending on the nature of the industry and market conditions.
Quick ratio
It measures the company’s ability to pay current liabilities using current assets after excluding inventory, as inventory is less liquid compared to other assets.
- Calculation method: Current Assets – Inventory\Current Liabilities.
- Interpretation
A 1:1 ratio is the standard, meaning that quick assets cover current liabilities.
Higher than 1:1 means that the company is in a strong financial position and is able to meet its obligations without having to liquidate inventory.
Net working capital ratio
It is a type of financial ratio, that expresses the difference between current assets and current liabilities, and reflects the ability to finance daily operations.
- Calculation method: current assets – current liabilities.
Interpretation
A high ratio indicates a good ability to cover current liabilities.
Low indicates that the company may have difficulty financing daily operations.
The higher the ratio, the more it indicates the efficiency of working capital management.
Operating cash flow ratio
It shows a company’s ability to pay current liabilities using cash flows generated from operating activities.
- Calculation method: Cash flow from operating activities\current liabilities.
Interpretation
A high ratio indicates that the company generates sufficient cash flows to cover current liabilities.
Low means that the company is having difficulties generating the cash needed to meet obligations.
Cash coverage ratio
It expresses the company’s ability to cover its daily operating expenses using cash and cash equivalents.
- Calculation method: Current assets – inventory – upfront expenses / daily operating expenses.
Interpretation
It refers to the period of time during which a company can finance its daily operating expenses using liquid assets.
A high ratio means that the company is in a stable financial position and can cover its daily expenses for a longer period of time.
A sample of types of financial ratios
If you want to download a model of different types of financial ratios to understand them more clearly, all you have to do is click here.
How to benefit from the Qoyod program in calculating financial ratios
The accounting program contributes to simplifying the process of calculating financial ratios, through the following:
Custom reports
The program provides the ability to create customized financial reports that meet the needs of different users, which helps in focusing on the important financial ratios for each company individually.
Real-time updates
Thanks to the cloud system that Qoyod operates on, data is updated in real time, meaning that the financial ratios derived are always based on the latest information available.
Integration with other systems
Qoyod supports integration with many other systems used in the company; This facilitates the process of collecting financial data from multiple sources and integrating them into one system for more accurate analysis.
Support and training
Qoyod provides comprehensive technical support and training to users to ensure that they can use all of the program’s features efficiently, and this training can include how to use the program to calculate financial ratios and interpret their results.
Conclusion
We realize that financial ratios are not just mathematical equations but rather windows that open deep strategic insights to us, as they contribute to guiding decisions and managing risks, allowing companies to excel in the competitive business environment. With an accounting program, such as Qoyod, the process of calculating and analyzing these ratios becomes easier and more effective, giving companies a real competitive advantage. So whether you are an ambitious business owner or a careful investor, remember that financial ratios are your best ally to achieve success and sustainability.
It is worth noting that the program also provides all its clients with: electronic invoice systems, as well as point-of-sale systems, stores, customers, and so on.
After knowing what financial ratios are and their types, try Qoyod now for free, for 14 days; It is an accounting program that turns your business into a success story.
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