Financial ratio offers a way to evaluate a company’s performance and compare it to similar companies. Understanding the ways to apply financial ratios to determine the success of an organization is an important element of finance management. Show What is Financial Ratio?It is a calculation where financial values are determined to get an insight into the overall financial health of a company and its market position. The value thus obtained can be used in the balance sheet, statement of cash flows, and other important financial statements. Each financial ratio needs a unique formula for its calculation, which leaves you with the tools necessary for your business evaluation. Types of financial Ratio1. Liquidity ratios – Liquidity ratios are one of the types of financial ratios that enable a company to determine its ability to pay its short and long-term obligations. The common liquidity ratios are:
2. Leverage ratio – Another type of financial ratio is the leverage ratio used to calculate a company’s debt levels.
3. Efficiency ratio – The efficiency ratio is another type of financial ratio that tells how well a company uses its resources and assets. Some common efficiency ratios are:
4. Profitability ratio – Another type of financial ratio is a profitability ratio used to determine the company’s ability to generate income in terms of revenue, its operating costs, equity and balance sheet assets. Common profitability financial ratios are:
5. Market value ratio – The market value ratio is a financial ratio that is used to determine the share price of a company’s stock. Uses of Financial RatioKnowing what financial ratio is not enough, as you should also understand how to implement it in a business for your benefit. Calculating financial ratios helps a business in two ways:
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Financial ratios are measurements of a business' financial performance. Ratios help an owner or other interested parties develop an understand the overall financial health of the company. Financial ratios are used by businesses and analysts to determine how a company is financed. Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability to pay off short term debts, and solvency is the ability to pay off long term debts. Commonly used financial ratios can be divided into the following five categories. Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The information you need to calculate these ratios can be found on your balance sheet, which shows your assets, liabilities, and shareholder's equity. Common liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is an indicator of your company's ability to pay its short term liabilities (debts). The quick ratio (sometimes called the acid-test) is similar to the current ratio. The difference between the two is that in the quick ratio, inventory is subtracted from current assets. Since inventory is sold and restocked continuously, subtracting it from your assets results in a more precise visual than the current ratio. The cash ratio is different from both the quick and current ratios in that it only takes into account assets that are the easiest to convert into cash. These assets are cash and cash equivalents, such as marketable securities, money orders, or money in a checking account. The solvency ratio represents the ability of a company to pay it's long term obligations. This ratio compares your company's non-cash expenses and net income after taxes to your total liabilities (short term and long term). The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. They use the firm's long-term liabilities on the balance sheet such as payable bonds, long-term loans, or pension funds. Common financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers to the amount of money and retained earnings invested in the company. The debt ratio indicates how much debt the firm is using to purchase assets. In other words, it shows if the company uses debt or equity financing. Sometimes called asset efficiency ratios, turnover ratios measure how efficiently a business is using its assets. This ratio uses the information found on both the income statement and the balance sheet. The turnover ratios used most commonly are accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts receivable turnover indicate how effective your company is at collecting credit debt. Accounts payable turnover expresses your efficiency at paying your accounts, and inventory turnover is a measurement of the amount of time it takes to consume and restock your inventory. When used together, turnover ratios describe how well the business is being managed. They can indicate how fast the company's products are selling, how long customers take to pay, or how long capital is tied up in inventory. These are ratios that measure if a business' activities are profitable. Frequently used ratios are the net profit ratio and the contribution margin ratio. The contribution margin ratio indicates if your products or services are generating a profit after variable expenses. The net profit ratio expresses profits after taxes to net sales. This ratio illustrates the percentage of profits remaining after taxes and all costs have been accounted for. There are many market value ratios, but the most commonly used are price per earnings (P/E) and dividend yield. The P/E ratio is used by investors to determine if a share of a company's stock is over or underpriced. The dividend yield is an important ratio for investors as it illustrates the return on their investment.
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