Introduction
Financial ratios are key metrics that allow experts to analyze the financial performance of business organizations. There are six primary types – liquidity, efficiency, solvency, coverage, profitability, and market value ratios. Each of them has unique objectives covering various areas of financial performance. Nevertheless, a thorough understanding of each type is necessary to determine the strengths and weaknesses of business organizations and propose the most appropriate strategy.
Explanation
Liquidity (Alexander, 2018; Carlson, 2022):
- Current Ratio (CR)=Current Assets/Current Liabilities (explanation in the instructions).
- Quick Ratio=Current Assets-Inventory/Current Liabilities; Same as CR but without selling inventory.
- Cash Ratio=Cash and Cash Equivalents/Current Liabilities; same as CR but without liquidating assets.
Efficiency:
- Inventory Turnover Ratio=Sales/Inventory; Estimates the period necessary to sell and restock inventory.
- Fixed Assets Turnover=Sales/Net Fixed Assets; Assesses the organization’s efficiency in using property and equipment.
- Total Assets Turnover=Sales/Total Assets; Evaluates how well the organization uses assets to generate profits.
Solvency:
- Total Debt (TD)=Total Liabilities/Total Assets; Estimates present assets by calculating liabilities and long-term debt.
- Debt-to-Equity=Total Liabilities/Total Assets – Total Liabilities; Same as TD but provides more illustrative information for investors.
Coverage:
- Debt Service Coverage (DSCR)=Net Income/Total Debt; Estimates the firm’s capacity to pay its debt obligations.
Profitability:
- Net Profit Margin=Net Income/Sales; Indicates profits based on sales.
- Basic Earning Power (BEP)=EBIT/Total Sales; Indicates overall profitability efficiency without taxes and debt.
- Return on Equity (ROE)=Net Income/Equity; Estimates efficiency of investments.
Market Value:
- Earnings per Share (EPS)=Net Income/Outstanding Shares; Estimates market value per each share.
- Price/Earnings (P/E)=Stock Price/Earnings; Evaluates how much investors might pay for stocks.
- Price/Cash Flow=Stock Price/Cash Flow per Share; Assesses the firm’s capacity to generate cash.
- Market/Book=Stock Price/Book Value; Presents an overview of investor perception and how much people are prepared to pay for stocks.
- Dividend Yield=Dividend Payments/Stock Price; Measures total passive income for investors.
- Dividend Payout=Dividend Payments/Net Income; Estimates passive income for investors relative to the firm’s earnings after tax.
Conclusion
In summary, the examined financial ratios provide valuable insights into the performance of business organizations. Each metric, depending on the category, focuses on unique areas of financial activity, allowing experts to make weighted decisions and propose thoughtful strategies. This information is helpful both for managers and investors who have to estimate the profitability of their acquisitions. Ultimately, understanding ratios is critical for any expert in the field of economics and financial performance.
References
Alexander, J. (2018). Financial planning & analysis and performance management. John Wiley & Sons.
Carlson, R. (2022). What is financial ratio analysis? The Balance. Web.