What Are the Categories of Financial Ratios?
Financial Ratios That Provide an Economic Portrait of a Business.
Financial ratios help a company's owner or its potential and current investors better understand the overall health of the company as well as its condition in various specific categories. In addition, tracking financial ratios over a period of time is a powerful way to identify trends in their early stages.
Ratios are also used by lenders and business analysts to determine a company's financial stability and standing. It's important to understand that financial ratios are time sensitive; they can only show a picture of a business at a given time. So the best way to use financial ratios is to conduct a ratio analysis on a consistent basis.
Financial ratios can be divided into five categories:
Liquidity or Solvency Ratios
The liquidity or solvency ratios focus on a firm's ability to pay its short-term debt obligations. As such, they focus on the firm's current assets and current liabilities on the balance sheet.
The most common liquidity ratios are the current ratio, the quick ratio, and the burn rate (interval measure). The quick ratio, as the name implies, determines how much money is available in the nearest term to pay current liabilities. The current ratio is a similar, but less stringent liquidity evaluation ratio. Burn rate measures how long a business can continue when current expenses exceed current income. It's a common measure used in evaluating start-ups, which almost always lose money as they begin to do business.
Burn rate answers the important question: how long at the current rate is the company going to be able to keep its doors open.
Financial Leverage or Debt Ratios
The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. It looks at the firm's long term liabilities on the balance sheet such as bonds.
The most common financial leverage ratios are the total debt ratios, the debt/equity ratio, the long-term debt ratio, the times interest earned ratio, the fixed charge coverage ratio, and the cash coverage ratio.
Although all slightly different, these financial leverage ratios all tell you about different aspects of the company's overall financial health and, in most instances, quantify shareholder equity.
Asset Efficiency or Turnover Ratios
The asset efficiency or turnover ratios measure the efficiency with which the firm uses its assets to produce sales. As a result, it focuses on both the income statement (sales) and the balance sheet (assets).
The most common asset efficiency ratios are the inventory turnover ratio, the receivables turnover ratio, the days' sales in inventory ratio, the days' sales in receivables ratio, the net working capital ratio, the fixed asset turnover ratio, and the total asset turnover ratio.
The asset efficiency ratios are particularly valuable in describing the business from a dynamic viewpoint. Used together, they describe how well the business is being run -- how fast its products are selling, how long customers take to pay and how much capital is tied up in inventory.
The profitability ratios are just what the name implies. They focus on the firm's ability to generate a profit and an adequate return on assets and equity. They measure how efficiently the firm uses its assets and how effectively it manages its operations and answer such basic questions as "How profitable is this business?" and "How does it measure up to its competitors?"
Market Value Ratios
The market value ratios can be calculated for publicly traded companies only as they relate to stock price. There are many market value ratios, but a few of the most commonly used are price/earnings (P/E), book value to share value and dividend yield