Financial ratios are quantitative measures used to evaluate a company’s financial performance and position. They provide insights into various aspects of a business, such as profitability, liquidity, efficiency, and solvency.
Characteristics
– Comparative Analysis: Financial ratios allow for comparisons between companies or against industry benchmarks.
– Trend Analysis: They help in analyzing a company’s performance over time by comparing ratios across different periods.
– Decision-Making Tool: Ratios assist investors, creditors, and management in making informed decisions regarding investments, lending, and operational strategies.
Examples
– Liquidity Ratios:
– Current Ratio: Measures a company’s ability to pay short-term obligations. Calculated as current assets divided by current liabilities.
– Quick Ratio: A more stringent measure of liquidity, calculated as (current assets – inventory) divided by current liabilities.
- Profitability Ratios:
- Gross Profit Margin: Indicates the percentage of revenue that exceeds the cost of goods sold, calculated as (gross profit divided by revenue) multiplied by 100.
Net Profit Margin: Shows the percentage of revenue that remains as profit after all expenses, calculated as (net income divided by revenue) multiplied by 100.
Efficiency Ratios:
- Inventory Turnover Ratio: Measures how efficiently a company manages its inventory, calculated as cost of goods sold divided by average inventory.
Accounts Receivable Turnover Ratio: Assesses how effectively a company collects receivables, calculated as net credit sales divided by average accounts receivable.
Solvency Ratios:
- Debt to Equity Ratio: Indicates the proportion of debt and equity used to finance a company’s assets, calculated as total liabilities divided by shareholders’ equity.
- Interest Coverage Ratio: Measures a company’s ability to pay interest on its outstanding debt, calculated as earnings before interest and taxes (EBIT) divided by interest expenses.