# What Are Financial Ratios? How to Make Them Right

## What is a financial ratio?

A financial ratio is defined as a coefficient or percentage calculated from the ratio of two masses. It is based on historical data (past or, in the best case, current) and provides no insight into a company’s future development.

It shows a company’s profitability, cost structure, productivity, solvency, liquidity, and financial balance, among other things.

## For what are financial ratios used?

Financial ratios are beneficial for both managers and accountants. They are divided into financial ratios and ratios used to examine the company’s financial balance.

Here are the financial measures that can assess a company’s solvency, financial autonomy, working capital, capital need (WCR), net cash, average trade receivables or payables to suppliers, stock rotation, etc. As a result, these analyses focus primarily on items related to the balance sheet and the ratios used to assess profitability.

The financial ratios used to assess profitability are calculated using elements from the income statement. It contains, for example, commercial margin rate, added value, EBITDA (gross operational surplus), net income, etc.

## How do you calculate financial ratios?

This section will review how to estimate and evaluate the most common financial ratios.

### Calculated financial ratios from a balance sheet

The key financial ratios calculated from a balance sheet are the financial independence ratio, available liquidity ratio, stable job coverage ratio, and obsolescence ratio.

### The ratio of financial independence

The financial independence ratio shows how the company’s financial debt stacks up against its equity. Here is how to figure it out:

Equity / Permanent capital (Permanent capital refers to shareholders’ equity, long-term provisions, and financial debt) = Financial independence ratio

A low ratio might make securing external funding more difficult because it suggests that the company is reliant on the entities that fund it and has little space for maneuvering created by its finances.

### The liquidity ratio in general

The general liquidity ratio assesses a firm’s ability to repay short-term loans.

Current assets / Current liabilities are the general liquidity ratio

(Inventories and trade receivables are current assets.) Supplier debts, tax obligations, and societal debts are current liabilities.

When it is more than one, the current assets allow at least the current liabilities to be funded. In the medium term, the corporation can be termed “solvent.”

### The consistent job coverage ratio

The steady employment coverage ratio evaluates the coverage rate of long-term assets by liabilities with the same horizon, represented as a percentage.

Permanent capital / Fixed assets (Fixed assets equal to gross fixed assets less depreciation) = Coverage ratio of steady jobs

The stability job coverage ratio must be at least one (100 percent). It is much better if it is higher than this because it signifies the company’s steady resources enable it to create excess cash that may be used to fund the working capital requirement.

### The ratio of obsolescence

The obsolescence ratio is a statistic that measures how much a company’s production equipment has worn out.

Net tangible fixed assets / Gross tangible fixed assets = Obsolescence ratio

The closer it gets to one, the more likely the production tool is new. Otherwise, it is a sign of age.

### Financial balance analysis

The balance sheet is the foundation for a type of analysis known as “functional analysis” (which requires it to be revised and displayed in the form of an available balance sheet) that allows you to emphasize an essential financial balance represented by the interaction of three variables:

### The obsolescence ratio

The obsolescence ratio is how worn out a company’s production equipment is.

Obsolescence ratio = Net tangible fixed assets / Gross tangible fixed assets

The closer it gets to one, the more likely the manufacturing tool is new. Otherwise, it is an indication of growing old.

## Analyze the financial situation

The balance sheet is the foundation for a type of analysis called “functional analysis” (which requires it to be amended and displayed in the form of an available balance sheet), which allows you to highlight an essential financial balance represented by the interplay of three variables:

Financial ratios make it feasible to do a financial study of a business, but they should not be the only factors considered. Furthermore, they must be in perfect harmony with the type of activity performed or any unique characteristics a company may have. Finally, the results must be compared through time (business evolution) and space (comparison of rival ratios).

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