Which of the following types of ratios measure how efficiently the organization is using its assets?

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.

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.
Still wondering what is a financial ratio? Let’s move ahead to understand more about it.

Types of financial Ratio

1. 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:

1. Current ratio – It is used to measure the ability of a company to pay its short-term liabilities using its current assets.
2. Acid-test ratio – It is used to measure the ability of a company to pay its short-term liability using assets that can be liquidated easily. Acid-test ratio gives insight into the value of the current assets that an organization can easily liquidate.
3. Cash ratio – It measures the ability of an organization to pay its short-term liability using cash and equivalents.
4. Operating cash flow ratio – It is a measure to find the number of times an organization can pay off its liability with the generated cash in a given duration.

2. Leverage ratio – Another type of financial ratio is the leverage ratio used to calculate a company’s debt levels.
Common leverage ratios are:

1. Debt ratio – It is the total debt of an organization to its total assets, and it is expressed in percentages. If the value is more than 1, an organization’s debt has more liabilities than assets.
2. Debt to equity ratio – It is a financial ratio that evaluates a company’s financial leverage by dividing its liabilities by shareholder equity. It tells you the borrowing patterns of your company and if your company is borrowing too much. If the value is between zero and one, we can say that the company has safe margins.
3. Interest coverage ratio – It measures how easily a company can pay off the interest on its outstanding debts. It is calculated by dividing the earnings of a business before taxes and interest by its interest expense in a given time.

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:

1. Asset-turnover ratio – measures the company’s ability to generate sales from its assets. Its value is directly proportional to a company’s efficiency.
2. Inventory turnover ratio – measures the number of times an organization’s inventory is sold over time.
3. Days sales inventory ratio – calculates the number of days that a company can hold on before selling its inventory to customers.

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:

1. Gross margin ratio – is an important financial metric that showcases the profit made by an organization after deducting the cost of sold goods. It measures the earnings of a company in each sale.
2. Operating margin ratio – measures how efficiently a company is generating revenue using its assets.
3. Return on equity ratio – calculates how efficiently a company is generating revenue using its equity.

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 Ratio

Knowing 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:

1. Enables a company to track its performance –Financial ratio helps a company in tracking its value over time. It helps in determining the trends developing in a company. Its importance can be understood by taking an example of a financial ratio – debt to asset ratio. A high debt-to-asset ratio may show a company that is overburdened by debt and may face default risk in the future.
2. Allows a company to make a comparative judgment regarding its performance – Financial ratios help a company determine its performance in terms of the industry average.

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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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