In the world of accounting, ratios give and invaluable amount of information about your company and it’s fiscal well being. Accountants use financial ratio analysis on a regular basis. These analyses help to evaluate the financial performance by comparing financial ratios of a business over various periods of time to other businesses in the same industry.
In his book Financial Analysis Tools and Techniques , financial expert Erich A. Helfert defines ratios analysis as:
“the use of a variety of ratios in analyzing the financial performance and condition of a business from various viewpoints such as managers, owners, and creditors.
Get out your financial calculator.
There are three different types of ratios:
Liquidity ratios measure your business short-term ability to pay bills as they are due and let you know if you have the cash to cover and unexpected expenses. Liquidity ratios compare your most liquid assets (assets that are easily turned into cash) with your short-term liabilities. In general, the greater the ratio of liquid assets to short-term liabilities, the better off your company is. These ratios let you know that your company can pay debts that are owed and still continue to operate normally.
- Current Ratios
- Acid Test Ratios
- Current Cash Debt Coverage
- Receivables Turnover
- Inventory Turnover
Profitability ratios measure the operating success of your company for a specific period of time. They give you a better understanding of how well your company made use of its resources to generate profit.
- Profitability Ratios
- Profit Margin
- Cash Return on sales
- Asset Turnover
- Return on Assets
- Return of Equity
Solvency ratios measure how well your business can survive over a long period of time by measuring your income after taxes. Solvency ratios take a look at your past financial statement analysis and let you know if your company can continue to pay its debts now and in the future by looking at your income after taxes. A ratio that is higher that 20% means that your business is financially healthy. The lower your ratio, the greater chance your company will default on its debt obligations.
- Solvency Ratios
- Debt to Asset
- Times Interest Earned
- Cash Debt Coverage
All of these ratios, liquidity, profitability, and solvency alike can provide you with useful financial information about your company. If you can get so much information from just looking at one type of ratio, imagine the invaluable knowledge you can gain to keep everything on track and guide your company to success.