This article throws light upon the four main types of financial ratios. The types are: 1. Liquidity Ratios 2. Activity Ratios 3. Leverage Ratios 4. Profitability Ratios.
Type # 1. Liquidity Ratios:
Liquidity ratios reflect the firm’s ability to meet scheduled short-term obligations. For the firm to remain alive, it must be able to pay its bills as they become due. Liquidity ratios measure the extent to which the firm can meat its immediate obligations. Liquidity ratios also reflect the firm’s ability to meet short term financial contingencies that might arise.
There are two commonly used liquidity ratios:
(a) Current Ratio:
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Current ratio, which relates current assets to current liabilities. Current assets include cash, bank balances, marketable securities (like stocks and bonds), accounts receivable and inventory. Current liabilities include accounts payable, bank loans, taxes payable and other accrued expenses.
Relatively high values of the current ratios are interpreted as an indication that the firm is liquid and in good position to meet its current obligations and vice-versa.
(b) Quick Ratio:
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Inventory is typically the least liquid component of current assets; the quick ratio is the same as the current ratio only with inventory subtracted from the numerator.
Like the current ratio, the quick ratio or acid-test ratio is meant to reflect the firm’s stability to pay its short term obligations and the higher the quick ratio, the more liquid the firm’s position.
Type # 2. Activity Ratios:
Activity ratios measure how well the firm is managing various classes of assets (like inventory and fixed assets). Activity ratios are called turnover ratios because they show how rapidly assets are being converted (turned over) into sales.
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High turnover ratios are generally associated with good asset management and vice-versa. Inventory turnover shows how efficiently the firm’s inventory is being managed. It is a rough measure of how many times per year the inventory level is replaced (turned over).
Generally higher than average inventory turnovers are suggestive of good inventory management and vice-versa. The collection period attempts to measure how efficient the firm’s collection policy is by calculating how long it takes to collect the firm’s accounts receivable.
Collection period figure (assume it calculates to be 40 days) really means this: Assuming all sales are made on credit, how many days’ worth of sales are tied up in receivables? Shorter collection periods are usually viewed as an indication that the firm’s receivables policy is fairly effective. Fixed assets turnover ratio is sales divided by fixed assets. This ratio is a measure of how well the firm uses its long term (fixed) assets.
In general, higher than average fixed assets turnover ratios are supposed to reflect better than average fixed asset management and vice versa. Total assets turnover is defined as sales divided by total assets.
In principle, high total assets turnover ratios are supposed to indicate successful asset management and vice versa.
Type # 3. Leverage Ratios:
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Leverage ratios show how much debt the firm has used to finance its investments. Leverage ratios indicate to what extent the firm has financed its investments by borrowing. Leverage ratios reflect the financial risk posture of the firm; the more extensive the use of debt, the larger the firm’s leverage ratios and more risk present in the firm.
While there are many leverage ratios, we will only look at two: the debt equity ratio and times interest earned. Debt equity ratio is the ratio of the total debt in the firm, both long-term and short term to equity, where equity is the sum of common and preferred stockholders’ equity.
A high ratio means that the firm has liberally used debt (has borrowed) to finance its assets and vice versa. Any ratio over 1.0 means the firm has used more debt than equity to finance its investments. Times interest earned is the sum of net income before taxes and interest expense divided by interest expense. It is supposed to measure how ably the firm can meet its interest obligations.
Type # 4. Profitability Ratios:
Profitability ratios are designed to reflect the profitability of the firm. These ratios tell the story about the firm’s past profitability.
Profitability ratios are:
The profit margin is an important ratio because it describes how well a rupee of sales is squeezed by the firm into profit.
The intent of this ratio is to measure how profitably the firm has used its assets. Net income
It indicates what kind of rate of return was earned on the book value of the owner’s equity.