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Four Basic Types of Financial Ratios Used to Measure a Company's Performance Financial ratios represent relationships between financial statement elements. Even though financial ratios provide historical data, management can use them to recognize internal strengths and weaknesses and to predict future financial performance. Investors often use financial ratios to compare companies within the same industry. Financial ratios are of no value as standalone numbers, but they are meaningful when compared to industry averages and historical data. Liquidity The most commonly used liquidity ratio is the current ratio (ratio of current assets to current liabilities). It shows the company’s ability to pay its short term debts. Current ratio that is greater than one is typically considered as a minimum because anything less than one denotes that the company has more liabilities than its assets. A high ratio demonstrates flexibility and a greater safety cushion as some of the inventory items and account receivable balances may not be easily convertible to cash. Companies can improve their current ratio by paying debts, converting short-term debt to long-term debt, collecting receivables and keeping fewer inventories on hand. Profitability The management’s ability to convert sales dollar into profits and cash flow are represented by profitability ratios. Profitability ratio includes gross margin, net income margin and operating margin. The gross margin is the ratio of gross profit to net sales. Gross profit is equal to sales minus cost of goods sold. The operating margin is the ratio of operating profit to sales and the net income margin is the ratio of net income to sales. The net income is equal to operating profit minus interest and taxes, while the operating profit is equal to gross profit minus operating expenses. The return-on-asset ratio measures company’s effectiveness in deploying its assets to generate profits. The return-on-investment indicates a company’s ability to generate a return for its owners. Solvency Solvency ratios measure the company’s debt relative to its assets and equity. They also help in indicating the financial stability of the company. A company that has high debt may not have the flexibility to manage its cash flow if interest rates rise or if the business conditions deteriorate. Debt-to-asset and debt-to-equity are the commonly used solvency ratios. The 1
debt-to-asset ratio is the ratio of total debt to total assets. The debt-to-equity ratio is the ratio of total debt to shareholder’s equity, which is the difference between total assets and total liabilities. Efficiency The most widely used efficiency ratios are receivable turnover and inventory turnover. A receivable turnover is the ratio of credit sales to accounts receivable, which helps in tracking outstanding credit sales. If the receivable turnover is high, it denotes that the company is successful in collecting its outstanding credit balances. Inventory turnover is the ratio of cost of goods sold to inventory. A high inventory turnover ratio shows that the company is successfully converting its inventory into sales. These financial ratios are used comparatively in two main fashions: over time and against other companies. Comparing the same ratios for company overtime is a great way to identify company’s trend. If some ratios are steadily improving it may suggest an improvement in the company’s operation or financial position. Conversely, if certain ratios are getting worse, it may highlight troubling factors about the company. Reference http://www.researchomatic.com/Financial-Ratios-131207.html
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