Financial Ratios: 3 Ways to Use Financial Ratio Analysis

Financial ratios compare two numerical values from a company’s financial statements to determine the company’s performance. These ratios take stock of current assets and balance sheet figures to compare values (such as income statements, cost of goods sold, etc.) to provide a quick look at the financial health of a company.

Small businesses and larger corporations alike rely on different types of financial ratios to better understand their valuation and economic place in the marketplace. For example, a company might divide its net income by total assets using the return on assets (ROA) ratio to determine stock opportunities.

Financial ratios determine a company’s ability to predict return on investment, effects of long-term debt, and other important factors. The types of ratios companies use to support their financial management include:

1. 1. Profitability ratios: Profitability ratios include the gross profit margin ratio, the percentage of a company's revenue that's greater than its cost of goods sold, and the net profit margin ratio, which divides net profit by net sales. Other ways to examine profit include comparing product price to earnings and net income to average shareholders’ equity.
2. 2. Liquidity ratios: Liquidity ratios are metrics that take stock of liquid, spendable money companies can use to pay off debt or invest in new developments. Some examples include cash ratios (cash and marketable securities/current liabilities), the current ratio or working capital ratio (current assets/current liabilities), and acid tests (current assets/current liabilities and marketable securities).
3. 3. Debt ratios: Debt ratios, also known as leverage ratios or solvency ratios, measure a company’s ability to repay long- and short-term debt. There are a few different kind of financial leverage ratios. The debt-to-equity ratio, for instance, adds long-term debt to value of leases and divides that sum by average shareholders’ equity. The debt-service coverage ratio divides net operating income by total debt service.
4. 4. Efficiency ratios: Efficiency ratios measure the effectiveness of a company’s group of resources. Some examples include the average collection period ratio (accounts receivable/credit sales per day) or asset turnover ratio (net sales/average total assets).
5. 5. Market ratios: A market ratio measures the cost of issuing stocks and how investors respond to owning a piece of a company via the organization’s financial performance. There are payout ratios (dividends/earnings), earnings per share (net earnings/number of shares), and other market ratios.

A financial statement analysis gives companies a barometer to measure their success against others in their field. Some benefits of using these ratios include understanding:

1. 1. Investment opportunities: Return on equity (ROE) is one of the most important profitability ratios, measuring net income against average shareholders’ equity to determine how well a company is making use of its investment. This ratio lets stakeholders hold a company responsible for its spending and profits, and also allows a company to analyze how well it is making use of seed funding.
2. 2. Spending capabilities: Quick ratios lead companies to understand how much it can spend. The acid test ratio, for example, measures current assets against current liabilities so companies can prioritize what to pay off and spend money on over a set period.
3. 3. Inventory ordering: Some ratios such as the average inventory conversion ratio divide 365 days by the inventory turnover. This empowers companies to purchase wisely, determining high seasons and consumer demand to strategically execute spending.

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