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Understanding Financial Ratios

Liquidity Ratios

Liquidity refers to a company’s ability to pay its outstanding obligations in the short term. Two ratios commonly used in assessing a company’s liquidity are:

Current Ratio = Current Assets / Current Liabilities
Quick ratio = (Current Assets – Inventories) / Current Liabilities

Liquidity ratios measure a company’s ability to meet its short-term obligations. The current ratio measures the current assets available to cover one unit of current liabilities. A higher ratio indicates a higher level of liquidity; if the current ratio is greater than 1, current assets are greater than current liabilities and the company appears to be able to cover its debts in the short term. But not every current asset is easily or quickly convertible into cash, so a current ratio of 2 is frequently used as a minimum desirable standard.

Another liquidity ratio, the quick ratio, excludes inventories, which are the least liquid current asset. This ratio is a better indicator than the current ratio of what would happen if the company had to settle with all its creditors at short notice. A quick ratio of 1 or higher is often viewed as desirable. However, a high current or quick ratio is not necessarily indicative of a problem-free company. It may also indicate that the company is holding too much cash and not investing in other resources necessary to create more profit.

Profitability Ratios

A widely used ratio for measuring a company’s profitability is the net profit margin.

Net Profit Margin = Net Income / Revenues

This ratio measures the percentage of revenues that is profit—that is, the percentage of revenues left for the shareholders after all expenses have been accounted for. Generally, the higher the net profit margin, the better.

Another ratio used to assess profitability is return on assets (ROA).

Return on Assets = Net Income / Total Assets

Return on assets indicates how much return, as measured by net income, is generated per monetary unit invested in total assets. Generally, the higher the return on assets, the better.

Financing Ratios

A common accounting ratio used for assessing financial leverage, which is the extent to which debt is used in the financing of the business, is the debt-to-equity ratio.

Debt to Equity Ratio = Debt / Equity

This ratio measures how much debt the company has relative to equity. Typically, the debt considered is only interest-bearing debt, including short-term borrowing, the portion of long-term debt due within the reporting period, and long-term debt. It does not include accounts payable and accrued expenses that do not require an interest payment.

Another common ratio is the financial leverage or equity multiplier ratio.

Equity Multiplier Ratio = Total Assets / Equity

This equity multiplier measures the amount of total assets supported by one monetary unit of equity. The greater the value of the assets relative to equity, the more debt is being used as financing. A company with a low financial leverage or equity multiplier is one predominantly financed by equity.

Shareholder Return Ratio

It is important to determine whether the return made by the company is sufficient from the perspective of the shareholders. That is, is the return high enough for investors to still want to own the share? One ratio commonly used to answer this question is return on equity (ROE).

Return on Equity = Net Income / Equity

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