What Are the Categories of Financial Ratios?
Financial Ratios Provide an Economic Portrait of a Business
Financial ratios help a company's owner or its current and potential investors better understand the overall health of the company as well as its condition in various specific financial performance categories. In addition, tracking financial ratios over a period of time, against other companies and against the company's industry as a whole offer a powerful way to identify trends in their early stages.
Lenders and business analysts often use ratios to determine a company's financial stability and standing. Financial ratios are time sensitive, however; they can only show a picture of a business at a given point in time. The best way to use financial ratios is to conduct ratio analysis on a consistent basis.
Commonly-used financial ratios can be divided into the following 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.
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.
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, telling how fast the company's 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 reveal a firm's ability to generate a profit and an adequate return on assets and equity. These ratios measure how efficiently the firm uses its assets, how effectively it manages its operations, and they answer such basic questions as "How profitable is this business?" and "How does it measure up to its competitors?" Common profitability ratios include the gross profit margin, net income margin, return on assets, and return on equity.
Market Value Ratios
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.