Financial ratios are a way for managers, stockholders, and creditors to determine the financial health of a company. There are five different types of financial ratios. They are: liquidity, activity, debt, profitability, and market. Liquidity, activity and debt ratios help determine the risk of the company. Market ratios help determine the risk and return of a company. Profitability ratios help measure return (Gitman, 2009). I will be discussing four of the five ratios.
Liquidity Ratios
Liquidity ratios determine the ability of a company to pay off their short term debt. The higher the ratio the easier it is for the company to pay off the debt. Creditors are interested in liquidity ratios because they show how quickly the business can generate the cash needed to pay the bills. Banks are interested in liquidity ratios because they will tend to extend loans to companies that have a higher percentage of assets to liabilities. There are two common types of liquidity ratios. They are: current ratio and quick (acid-test) ratio (Gitman, 2009). The current ratio formula is current assets/current liabilities. The quick ratio is similar to the current ratio, but it does not include inventory. Inventory is excluded in certain cases because some companies have a hard time turning their inventory into cash. Just like the current ratio, the higher the ratio is the better.
Activity Ratios
Activity ratios measure a company’s ability to turn various balance sheet accounts into cash or sales. Some examples of activity ratios are: Inventory turnover, average collection period, average payment period, and total asset turnover. Inventory turnover measures the liquidity of the company. Average collection period measures how fast a company receives money from their customers. Average payment period is the average number of days a company pays off its debts. Total asset turnover measures how well a company uses their assets to generate sales (Gitman, 2009). Activity ratios are important to banks and investors because the more efficiently the company can turn its accounts into cash the more likely banks will lend to them and the more likely the company will attract investors.
Debt Ratios
Debt ratios are used to indicate how much debt a company has. The higher the number the more the company is at risk of going bankrupt (Gitman, 2009). This ratio is very important to banks and investors. If the company is at risk of going bankrupt the more unlikely a bank will want to lend funds or extend a loan to them. Investors will not be interested in a risky company.
Profitability Ratios
Profitability ratios determine a company’s ability to generate profit from their sales or investments. Some examples of profitability ratios are: gross profit margin, operating profit margin, net profit margin, earnings per share, return on total assets, and return on common equity (Gitman, 2009). Profit ratios are extremely important to banks and investors. Investors would be especially interested in the earnings per share ratio or their return on investment (total assets). Banks are interested in the company’s profitability because it would be risky for the bank to lend money or extend loans to companies that are not profitable.
References:
Gitman, L. J. (2009). Principles of managerial finance. 12th Edition.
Pearson Prentice Hall. San Diego State University.
