# How to Understand Financial Ratios

29.07.2013

Businesses use financial ratios to compare performances of various business activities over a period of time. Since trends keep changing with time, it is recommended comparing ratios of current year to earlier years as calculating ratios for one year doesn’t really serve much purpose. Any business would need to compare its financial ratios to standards prevailing for that industry. Industrial surveys come handy for knowing such standards. However, certain businesses perform better during particular parts of the year. This fact should be taken into consideration while making comparisons. Before you start comparing different ratios you should know how to understand financial ratios.

Liquidity Ratios

Liquidity ratio is calculated to know the ability of business to suit interim debt obligations.  Quick ratio and current ratio are the two frequently used liquidity ratios. Current assets ÷ by current liabilities give current ratios. Quick ratios = present assets-inventory÷ present liabilities.

This is how the ratios so obtained are analyzed:

When the quick or current ratio is above 1.0, the business is considered to have adequate assets to meet requirements of interim debts. Creditors look at higher ratios as a positive sign as it implies lower chances of business being unable to honor its obligations.

Now, let’s see how shareholders interpret these ratios. They treat lower ratio valuable as it indicates that the company is exploiting its assets to enhance its operations.

Asset Turnover Ratios

Calculating asset turnover ratios tells us how competently the business is using its assets.

Sum of credit sales ÷ sum of receivable accounts= receivables turnover. Cost of merchandise sold ÷ average annual inventory= inventory turnover.

To have a better analysis, find out the average period of collecting receivables. Divide 365 days contained in one year by receivable turnover ratio already calculated. The resultant figure tells you how many days the business spends to collect payment of merchandise sold on credit. If period for collecting payments is large, it means the business needs to modify its credit collection policies.

On dividing 365 by inventory turnover, you can get inventory period. Quite like average collection period, a larger inventory period is not healthy. The larger the inventory held by business the larger is the risk of its going obsolete and hence reduction of its value.

Financial Leverage Ratios

Compute financial leverage ratios to know the long term solvency of company. Find out debt ratio which is equal to total debt÷ total assets. Also find out debt to equity ratio which equals total debt ÷ total equity. These ratios rely on how short term and long term debts are categorized by business.

On analyzing financial leverage ratios, if the value is smaller than 1, it is considered to be in normal range. Nevertheless, it is recommended to check with industry specific benchmarks.

Income before interest and taxes÷ total interest outlay= interest coverage ratio that tells us the extent to which the income from business may be utilized for making interest payments on debts.

Profitability Ratios

Profitability ratio is calculated to assess performance of business over time and to know how it compares to others from that industry. Revenue-cost of merchandize÷ total revenue= Gross profit margin. This evaluates gross profit created by sales.

To find out how effectively the business is using its assets to create profit, divide net income by sum of assets.

Shareholders’ earning per dollar of their investment = net income ÷ total equity.

Whether you are in business or an investor, now you would know How to Understand Financial Ratios.

Businesses use financial ratios to compare performances of various business activities over a period of time. Since trends keep changing with time, it is recommended comparing ratios of current year to earlier years as calculating ratios for one year doesn’t really serve much purpose. Any business would need to compare its financial ratios to standards prevailing for that industry. Industrial surveys come handy for knowing such standards. However, certain businesses perform better during particular parts of the year. This fact should be taken into consideration while making comparisons. Before you start comparing different ratios you should know how to understand financial ratios.

Liquidity Ratios

Liquidity ratio is calculated to know the ability of business to suit interim debt obligations.  Quick ratio and current ratio are the two frequently used liquidity ratios. Current assets ÷ by current liabilities give current ratios. Quick ratios = present assets-inventory÷ present liabilities.

This is how the ratios so obtained are analyzed:

When the quick or current ratio is above 1.0, the business is considered to have adequate assets to meet requirements of interim debts. Creditors look at higher ratios as a positive sign as it implies lower chances of business being unable to honor its obligations.

Now, let’s see how shareholders interpret these ratios. They treat lower ratio valuable as it indicates that the company is exploiting its assets to enhance its operations.

Asset Turnover Ratios

Calculating asset turnover ratios tells us how competently the business is using its assets.

Sum of credit sales ÷ sum of receivable accounts= receivables turnover. Cost of merchandise sold ÷ average annual inventory= inventory turnover.

To have a better analysis, find out the average period of collecting receivables. Divide 365 days contained in one year by receivable turnover ratio already calculated. The resultant figure tells you how many days the business spends to collect payment of merchandise sold on credit. If period for collecting payments is large, it means the business needs to modify its credit collection policies.

On dividing 365 by inventory turnover, you can get inventory period. Quite like average collection period, a larger inventory period is not healthy. The larger the inventory held by business the larger is the risk of its going obsolete and hence reduction of its value.

Financial Leverage Ratios

Compute financial leverage ratios to know the long term solvency of company. Find out debt ratio which is equal to total debt÷ total assets. Also find out debt to equity ratio which equals total debt ÷ total equity. These ratios rely on how short term and long term debts are categorized by business.

On analyzing financial leverage ratios, if the value is smaller than 1, it is considered to be in normal range. Nevertheless, it is recommended to check with industry specific benchmarks.

Income before interest and taxes÷ total interest outlay= interest coverage ratio that tells us the extent to which the income from business may be utilized for making interest payments on debts.

Profitability Ratios

Profitability ratio is calculated to assess performance of business over time and to know how it compares to others from that industry. Revenue-cost of merchandize÷ total revenue= Gross profit margin. This evaluates gross profit created by sales.

To find out how effectively the business is using its assets to create profit, divide net income by sum of assets.

Shareholders’ earning per dollar of their investment = net income ÷ total equity.

Whether you are in business or an investor, now you would know How to Understand Financial Ratios.