Financial ratios are measurements of a business' financial performance. Ratios help an owner or other interested parties develop an understand the overall financial health of the company.
Financial ratios are used by businesses and analysts to determine how a company is financed. Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability to pay off short term debts, and solvency is the ability to pay off long term debts.
Commonly used financial ratios can be divided into the following five categories.
Liquidity and Solvency Ratios
Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The information you need to calculate these ratios can be found on your balance sheet, which shows your assets, liabilities, and shareholder's equity.
Common liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is an indicator of your company's ability to pay its short term liabilities (debts).
The quick ratio (sometimes called the acid-test) is similar to the current ratio. The difference between the two is that in the quick ratio, inventory is subtracted from current assets. Since inventory is sold and restocked continuously, subtracting it from your assets results in a more precise visual than the current ratio.
The cash ratio is different from both the quick and current ratios in that it only takes into account assets that are the easiest to convert into cash. These assets are cash and cash equivalents, such as marketable securities, money orders, or money in a checking account.
The solvency ratio represents the ability of a company to pay it's long term obligations. This ratio compares your company's non-cash expenses and net income after taxes to your total liabilities (short term and long term).
Financial Leverage Ratios
The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. They use the firm's long-term liabilities on the balance sheet such as payable bonds, long-term loans, or pension funds.
Common financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers to the amount of money and retained earnings invested in the company.
The debt ratio indicates how much debt the firm is using to purchase assets. In other words, it shows if the company uses debt or equity financing.
Sometimes called asset efficiency ratios, turnover ratios measure how efficiently a business is using its assets. This ratio uses the information found on both the income statement and the balance sheet.
The turnover ratios used most commonly are accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts receivable turnover indicate how effective your company is at collecting credit debt.
Accounts payable turnover expresses your efficiency at paying your accounts, and inventory turnover is a measurement of the amount of time it takes to consume and restock your inventory.
When used together, turnover ratios describe how well the business is being managed. They can indicate how fast the company's products are selling, how long customers take to pay, or how long capital is tied up in inventory.
These are ratios that measure if a business' activities are profitable. Frequently used ratios are the net profit ratio and the contribution margin ratio. The contribution margin ratio indicates if your products or services are generating a profit after variable expenses.
The net profit ratio expresses profits after taxes to net sales. This ratio illustrates the percentage of profits remaining after taxes and all costs have been accounted for.
Market Value Ratios
There are many market value ratios, but the most commonly used are price per earnings (P/E) and dividend yield.
The P/E ratio is used by investors to determine if a share of a company's stock is over or underpriced. The dividend yield is an important ratio for investors as it illustrates the return on their investment.