Financial ratios are often used to analyze the financial statements. They help the users to form conclusions about the financial health of the entity. Ratios can be used to form conclusions on the level of liquidity, leverage and profitability of a company’s financial statements. These ratios can also be used to compare companies with each other if they share similar qualities, or they can be used to compare the current financial data of a company to its own historical ratios.
Liquidity ratios represent a company’s ability to convert its current assets into cash in order to repay its current liabilities. The most commonly used ratio to measure liquidity is the quick ratio, in which you take the current assets (excluding inventory) divided by current liabilities. Inventory is not included in the calculation as it can’t usually be quickly converted into cash. A higher quick ratio would be preferred, and it would represent a company that has a strong ability to pay all of its current liabilities. On the other hand, a lower quick ratio would mean a company may not have the ability to pay its current obligations.
Leverage ratios are used to evaluate how much debt a company is using to finance its operations. This ratio also gives the user some insight into the ability of the company to meet its financial obligations, and the degree to which they use debt to do so. A common leverage ratio is the debt to equity ratio, which takes total debt divided by total equity. Generally, companies will want to have a lower debt to equity ratio as that shows that the company can meet its financial obligations with the use of little or no debt.
Profitability ratios are used to show a company’s ability to generate earnings relative to its expenses. A commonly used profitability ratio is the net profit margin, which is calculated by dividing net income by net sales. The ratio represents the amount of net income earned for each dollar of sales revenue. It shows a company’s ability to produce income through its operations. In general, companies would try to maintain a higher net profit margin, as this means that a higher percentage of every sales dollar is being realized as net income.
There are many other ratios within these categories that can be used to evaluate financial statements of an organization. Another important reason to be familiar with these ratios is that banks will often require a company to meet certain thresholds in order to obtain financing; some of the requirements are often attainment of a certain level within these financial ratios.