Financial Ratios

What it does:
Analyzes an organization's finances and performance using data collected from financial statements.

Where it comes from:
Financial ratios analyze an organization's finances and performance using data collected from financial statements.

Summary:
The most commonly used and useful financial ratios are:
- Asset turnover ratios
- Financial leverage ratios.
- Liquidity ratios
- Profitability ratios

Let's take a closer look at each.

Asset Turnover Ratios
The most commonly used Asset Turnover Ratios are:

Receivables turnover:
Quickly shows how widely accounts receivable are distributed among different accounts due.

Average collection period:
A quick barometer for how quickly an organization collects amounts outstanding.

Inventory period:
Indicates the amount of time inventory remains in-house. Note that inventory is represented by dollar value in this ratio.

Financial Leverage Ratios
The most commonly used Financial Leverage Ratios are:

The debt ratio:
A useful predictor of financial stability.

The debt-to-equity ratio:
Another barometer for a company's financial health and long-term viability.

Times interest earned ratio:
Helps predict how well a company's profits are able to pay the interest on its debt

Liquidity Ratios
The most commonly used Liquidity Ratios are:

The current ratio:
Divides current assets by current liabilities to track short-term debt management In general, a high current ratio indicates low risk. However, in some cases a lower ratio may be preferable, indicating that more of a firm's budget is being expended on labor, product development, or other positive activities.

The quick ratio (the "acid test"):
Weighs assets against debt, a quick way to determine an organization's health

The cash ratio:
Indicates an organization's ability to keep operating in the event of a crisis.

Profitability Ratios
The most commonly used Profitability Ratios are:

Gross profit margin:
Shows the profit earned on sales.

Return on Assets:
Indicates how profits are generated from an organization's assets

Return on equity:
Measures the profit that accrues from each dollar that investors have put into the company's stock.

What else you need to know:
Ratios take on more meaning the longer they have been recorded. How good is performance this year, as opposed to two years ago? Remember too that ratios can change at different points in the fiscal year. Above all, they are only as dependable as the methods used to generate the raw statistics that go into them.