What Are Financial Ratios?

Financial ratios are important, because the dizzying array of numbers contained in a financial statement give even experienced quantitative analysts pause. Fortunately, financial ratios can help you zero in on the critical factors before you decide to invest.

Investors

Financial ratios vary by industry, so it is important to familiarize yourself with the industry before diving into the numbers. You will need to do apples-to-apples comparisons of different companies within the same industry in order to truly understand which are the top performers. You will also need to take the company’s historical performance into consideration.

Just as there are a lot of numbers in a financial statement, there are a lot of financial ratios to put those numbers in perspective. To make them easier to identify and understand, they are generally broken up into six categories.

Liquidity Ratios

Liquidity ratios give you a snapshot of the ability of a company to pay off its debt, in the short term. The more liquid assets a company has, the better its position to pay debts that come due in the near future. Also, these ratios are used by lenders when issuing short-term credit.

Operating Efficiency Ratios

Operating efficiency ratios consist of sales or revenue per employee and fixed-asset turnover, as well as the operating cycle. They offer an indication of how well a company is utilizing its resources to increase shareholder value. Strong ratios here are a good indicator of positive performance for shareholders.

Cash Flow Ratios

Cash flow ratios will tell you how well the company generates cash from its profits. Ideally, a strong performing company will generate more than enough cash to cover obligations.

Profitability Ratios

Profitability ratios measure how effective a company is at generating profit and, ultimately, value for shareholders. There are different ways to measure profitability, including return on assets, return on equity and gross profit margin.

Debt Ratios

Debt ratios will give you an idea of how well the company is leveraged. Naturally, the more debt a company carries, the higher the risk of the company going bankrupt.

Market Ratios

Market ratios are a general category for investors that include ratios such as price to earnings, price to sales per share, dividend yield, and much more. These ratios help investors determine the value of a company.