Financial ratios are mathematical comparisons of financial statement accounts or categories.

These relationships between the financial statement accounts help investors, creditors, and internal
company management understand how well a business is performing and of areas needing
improvement.
Financial ratios are the most common and widespread tools used to analyze a business’ financial
standing. Ratios are easy to understand and simple to compute. They can also be used to compare
different companies in different industries. Since a ratio is simply a mathematically comparison
based on proportions, big and small companies can be use ratios to compare their financial
information. In a sense, financial ratios don’t take into consideration the size of a company or the
industry. Ratios are just a raw computation of financial position and performance.
Ratios allow us to compare companies across industries, big and small, to identify their strengths
and weaknesses. Financial ratios are often divided up into seven main categories: liquidity,
solvency, efficiency, profitability, market prospect, investment leverage, and coverage.

Liquidity Ratios
Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they
become due as well as their long-term liabilities as they become current. In other words, these
ratios show the cash levels of a company and the ability to turn other assets into cash to pay off
liabilities and other current obligations.
Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy
it will be for the company to raise enough cash or convert assets into cash. Assets like accounts
receivable, trading securities, and inventory are relatively easy for many companies to convert into
cash in the short term. Thus, all of these assets go into the liquidity calculation of a company.
I. The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off
its short-term liabilities with its current assets. The current ratio is an important measure of
liquidity because short-term liabilities are due within the next year.
This means that a company has a limited amount of time in order to raise the funds to pay
for these liabilities. Current assets like cash, cash equivalents, and marketable securities
can easily be converted into cash in the short term. This means that companies with larger
amounts of current assets will more easily be able to pay off current liabilities when they
become due without having to sell off long-term, revenue generating assets.
II. Days cash on hand is the number of days that an organization can continue to pay its
operating expenses, given the amount of cash available. Managers should be aware of
the days cash on hand in the following circumstances: When a business is starting up,
and is not yet generating any cash from sales. During the low part of a seasonal sales
cycle, when there may be no sales. During a transition to a new product line, when
sales of the old product line are poor and declining.
A key assumption in determining days cash on hand is that there is no cash flow from
sales; instead, there are just operating expenses, such as salaries, rent, and utilities. To
determine the amount of these operating expenses, use the operating expenses subtotal
in the income statement, and subtract all non-cash expenses (usually depreciation and
amortization). Then divide by 365 to determine the amount of cash outflow per day.
Finally, divide the cash outflow per day into the total amount of cash on hand.
Profitability Ratios
Profitability ratios compare income statement accounts and categories to show a company’s ability
to generate profits from its operations. Profitability ratios focus on a company’s return on
investment in inventory and other assets. These ratios basically show how well companies can
achieve profits from their operations.
Investors and creditors can use profitability ratios to judge a company’s return on investment based
on its relative level of resources and assets. In other words, profitability ratios can be used to judge
whether companies are making enough operational profit from their assets. In this sense,
profitability ratios relate to efficiency ratios because they show how well companies are using thier
assets to generate profits. Profitability is also important to the concept of solvency and going
concern.
I. The total margin ratio is the percentage calculated by dividing excess revenues less
expenses, or net income, by total revenues. It is the ratio of total income to total
revenues. It provides the percentage of gross revenue realized as net income. The total
margin provides a measure of a hospital's overall profitability utilizing the net income
or loss or, in nonprofit and government terminology, operating and non-operating
surplus or loss. Many analysts use total margin ratio as the primary measure of a
hospital's profitablity.
II. The operating margin ratio, also known as the operating profit margin, is a profitability
ratio that measures what percentage of total revenues is made up by operating income.
In other words, the operating margin ratio demonstrates how much revenues are left
over after all the variable or operating costs have been paid. Conversely, this ratio
shows what proportion of revenues is available to cover non-operating costs like
interest expense.
This ratio is important to both creditors and investors because it helps show how strong
and profitable a company’s operations are. For instance, a company that receives 30
percent of its revenue from its operations means that it is running its operations
smoothly and this income supports the company. It also means this company depends
on the income from operations. If operations start to decline, the company will have to
find a new way to generate income.
Conversely, a company that only converts 3 percent of its revenue to operating income
can be questionable to investors and creditors. The auto industry made a switch like
this in the 1990’s. GM was making more money on financing cars than actually
building and selling the cars themselves. Obviously, this did not turn out very well for
them. GM is a prime example of why this ratio is important.
III. The return on assets ratio, often called the return on total assets, is a profitability ratio
that measures the net income produced by total assets during a period by comparing
net income to the average total assets. In other words, the return on assets ratio or ROA
measures how efficiently a company can manage its assets to produce profits during a
period.
Since company assets’ sole purpose is to generate revenues and produce profits, this
ratio helps both management and investors see how well the company can convert its
investments in assets into profits. You can look at ROA as a return on investment for
the company since capital assets are often the biggest investment for most companies.
In this case, the company invests money into capital assets and the return is measured
in profits.
 IV. The return on equity ratio or ROE is a profitability ratio that measures the ability of a
firm to generate profits from its shareholders investments in the company. In other
words, the return on equity ratio shows how much profit each dollar of common
stockholders’ equity generates.
So a return on 1 means that every dollar of common stockholders’ equity generates 1
dollar of net income. This is an important measurement for potential investors because
they want to see how efficiently a company will use their money to generate net income.
ROE is also and indicator of how effective management is at using equity financing to
fund operations and grow the company.

Financial Leverage Ratios

Financial leverage ratios, sometimes called equity or debt ratios, measure the value of equity in a
company by analyzing its overall debt picture. These ratios either compare debt or equity to assets
as well as shares outstanding to measure the true value of the equity in a business.
In other words, the financial leverage ratios measure the overall debt load of a company and
compare it with the assets or equity. This shows how much of the company assets belong to the
shareholders rather than creditors. When shareholders own a majority of the assets, the company
is said to be less leveraged. When creditors own a majority of the assets, the company is considered
highly leveraged. All of these measurements are important for investors to understand how risky
the capital structure of a company and if it is worth investing in.
I. Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of
its total assets. In a sense, the debt ratio shows a company’s ability to pay off its
liabilities with its assets. In other words, this shows how many assets the company must
sell in order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher levels
of liabilities compared with assets are considered highly leveraged and more risky for
lenders.
This helps investors and creditors analysis the overall debt burden on the company as
well as the firm’s ability to pay off the debt in future, uncertain economic times.
II. The debt to equity ratio is a financial, liquidity ratio that compares a company’s total
debt to total equity. The debt to equity ratio shows the percentage of company financing
that comes from creditors and investors. A higher debt to equity ratio indicates that
more creditor financing (bank loans) is used than investor financing (shareholders).
III. The times interest earned ratio, sometimes called the interest coverage ratio, is a
coverage ratio that measures the proportionate amount of income that can be used to
cover interest expenses in the future.
In some respects the times interest ratio is considered a solvency ratio because it
measures a firm’s ability to make interest and debt service payments. Since these
interest payments are usually made on a long-term basis, they are often treated as an
ongoing, fixed expense. As with most fixed expenses, if the company can’t make the
payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered
a solvency ratio.

Efficiency Ratios
Efficiency ratios also called activity ratios measure how well companies utilize their assets to
generate income. Efficiency ratios often look at the time it takes companies to collect cash from
customer or the time it takes companies to convert inventory into cash—in other words, make
sales. These ratios are used by management to help improve the company as well as outside
investors and creditors looking at the operations of profitability of the company.
Efficiency ratios go hand in hand with profitability ratios. Most often when companies are efficient
with their resources, they become profitable. Wal-Mart is a good example. Wal-Mart is extremely
good at selling low margin products at high volumes. In other words, they are efficient at turning
their assets. Even though they don’t make much profit per sale, they make a ton of sales. Each
little sale adds up.
I. The asset turnover ratio is an efficiency ratio that measures a company’s ability to
generate sales from its assets by comparing net sales with average total assets. In other
words, this ratio shows how efficiently a company can use its assets to generate sales.
The total asset turnover ratio calculates net sales as a percentage of assets to show how
many sales are generated from each dollar of company assets. For instance, a ratio of
.5 means that each dollar of assets generates 50 cents of sales.
II. The fixed asset turnover ratio is an efficiency ratio that measures a companies return
on their investment in property, plant, and equipment by comparing net sales with fixed
assets. In other words, it calculates how efficiently a company is a producing sales with
its machines and equipment.
Investors and creditors use this formula to understand how well the company is utilizing
their equipment to generate sales. This concept is important to investors because they
want to be able to measure an approximate return on their investment. This is
particularly true in the manufacturing industry where companies have large and
expensive equipment purchases. Creditors, on the other hand, want to make sure that
the company can produce enough revenues from a new piece of equipment to pay back
the loan they used to purchase it.
Management typically doesn’t use this calculation that much because they have insider
information about sales figures, equipment purchases, and other details that aren’t
readily available to external users. They measure the return on their purchases using
more detailed and specific information
III. Accounts receivable days is the number of days that a customer invoice is
outstanding before it is collected. The point of the measurement is to determine the
effectiveness of a company's credit and collection efforts in allowing credit to
reputable customers, as well as its ability to collect cash from them in a timely
manner. The measurement is usually applied to the entire set of invoices that a
company has outstanding at any point in time, rather than to a single invoice. When
measured at the individual customer level, the measurement can indicate when a
customer is having cash flow troubles, since it will attempt to stretch out the
amount of time before it pays invoices.
There is not an absolute number of accounts receivable days that is considered to
represent excellent or poor accounts receivable management, since the figure
varies considerably by industry and the underlying payment terms. Generally, a
figure of 25% more than the standard terms allowed represents an opportunity for
improvement. Conversely, an accounts receivable days figure that is very close to
the payment terms granted to a customer probably indicates that a company's credit
policy is too tight. When this is the case, a company is potentially turning away
 sales (and profits) by denying credit to customers who are more likely than not to
be able to pay the company.
Other Ratios
The price to book ratio, also called the P/B or market to book ratio, is a financial valuation
tool used to evaluate whether the stock a company is over or undervalued by comparing the price
of all outstanding shares with the net assets of the company. In other words, it’s a calculation that
measures the difference between the book value and the total share price of the company.
This comparison demonstrates the difference between the market value and book value of a
company. The market value equals the current stock price of all outstanding shares. This is the
price that the market thinks the company is worth. The book value, on the other hand, comes from
the balance sheet. It equals the net assets of the company.
Investors and analysts use this comparison to differentiate between the true value of a publicly
traded company and investor speculation. For example, a company with no assets and a visionary
plan that is able to drum up a lot of hype can have investors drooling over it. Thus, causing the
stock price to increase quarter over quarter. The book value of the company hasn’t changed though.
The business still has no assets.