Financial ratios help to provide an economic overview of a business.
Financial ratios are parameters that owners of a company need to check along with current or potential investors who can understand the financial health of a company overall as well as conditions under different categories. It is also imperative to track
financial ratios periodically, which showcase trends and patterns. There are five main types of financial ratios discussed here, along with significances of each. Evert category focuses on specific performance parameters.
Ratios also prove useful for business analysts,
merchant services and lenders who can understand the financial standing and the stability of a company accordingly. Financial ratios tend to be time sensitive; they showcase picture of financial health of a business at a given time period. It is best that
financial ratios are used and ratio analyses done in a periodic and consistent manner.
These are five main categories of financial ratios:
- Solvency and liquidity ratios
The
liquidity or solvency ratios help a firm to focus on its ability to pay off short term debts and similar obligations. These focus on the current liabilities and assets of a firm as showcased on a balance sheet.
The common liquidity ratios are quick ratio, current ratio and burn rate or interval measure. Quick ratio, as per the name, means the amount of money available as per nearest terms, for paying off current liabilities. Current ratio is a less stringent but
a similar ratio of evaluating liquidity. The burn rate on the other hand, measures the length of time in which a business can continue as well as the difference between current expenses and current income. This measure is relevant for startup ventures as they
tend to lose money at the beginning of doing business.
Burn rate helps to answer questions regarding the length of time that a business would be able to spend more than what it earns or sustaining a business.
Such ratios help a firm to focus on their ability to meet debt obligations that are long term. We look at long term liabilities of a firm that showcase on the balance sheet like bond products.
A common financial leverage ratio is total debt ratio or debt/equity ratio. Other similar ratios in this category are long term debt ratio, fixed charge coverage ratio, and times interest earned ratio, cash coverage ratio and so forth.
The ratios have differences but in general financial leverage ratios talk about different aspects such as the financial health of a company or the way shareholder equity is quantified.
- Asset turnover or efficiency ratios
The turnover or asset efficiency ratios talk about efficiency in the way a firm uses the assets in producing sales. The ratios focus on the income statement of sales or balance sheet of assets.
Common asset efficiency ratios are several such as an inventory turnover ratio, days’ sales in receivables ratio, receivables turnover ratio, fixed asset turnover ratio, net working capital ratio, total asset turnover ratio.
The asset efficiency ratios are helpful in describing how a business runs from a dynamic point of view. These ratios indicate how well a business is run – the rate at which products sell, the length of time customers takes to make payment, capital that remains
tied in inventory and so forth.
Profitability ratios showcase ability of a firm in generating profit as well as returns on equity and assets. These indicate how well a firm uses the assets and manages operations. These ratios showcase efficiency in using assets as well as managing operations.
Basic questions such as profitability of a business or measuring up to competitors are what are answered by these ratios.
These ratios such as price/earnings and book value to share value as well as dividend yield are usually shown by publicly traded companies. There are several ratios that showcase the market value of a company which also relate to stock prices and publicly
traded companies.