Financial ratios are one of the most important tools in understanding the financial health of a company. They can provide valuable insights into a company’s performance, liquidity, and profitability, as well as its ability to pay its debts. Financial ratios are used to compare the financial performance of companies within the same sector or industry. They can also be used to compare the performance of companies across different industries.

The major categories of financial ratios are profitability ratios, liquidity ratios, activity ratios, solvency ratios, and valuation ratios.

Profitability Ratios

Profitability ratios measure the company’s ability to generate profits. Examples include return on assets (ROA), return on equity (ROE), gross profit margin, operating profit margin, and net profit margin.

Return on Assets (ROA) is a ratio that measures a company’s ability to generate profits from its total assets. It is calculated by dividing the net income by the average total assets for the period.

Return on Equity (ROE) is a ratio that measures a company’s ability to generate profits from its shareholders’ equity. It is calculated by dividing the net income by the average shareholders’ equity for the period.

Gross Profit Margin is a ratio that measures the margin of profit a company earns from the sale of its products or services before taking into account taxes and other expenses. It is calculated by dividing the net sales by the cost of goods sold.

Operating Profit Margin is a ratio that measures the margin of profit a company earns from its operations before taking into account taxes and other expenses. It is calculated by dividing the net income from operations by total sales.

Net Profit Margin is a ratio that measures the overall profitability of a company. It is calculated by subtracting expenses, such as taxes and interest, from the net income.

Liquidity Ratios

Liquidity ratios measure a company’s liquidity, or its ability to meet its short-term financial obligations. Examples include the current ratio, quick ratio, and cash ratio.

Current Ratio is a ratio that measures a company’s ability to meet its short-term financial obligations by comparing its current assets to its current liabilities. It is calculated by dividing the current assets by the current liabilities.

Quick Ratio is a ratio that measures a company’s ability to meet its short-term financial obligations by comparing its liquid assets to its current liabilities. It is calculated by subtracting the current liabilities from the current assets.

Cash Ratio is a ratio that measures a company’s ability to meet its short-term financial obligations by comparing its liquid assets to its total liabilities. It is calculated by dividing the cash and cash equivalents by the total liabilities.

Activity Ratios

Activity ratios measure a company’s ability to manage its resources efficiently. Examples include inventory turnover, accounts receivable turnover, and asset turnover.

Inventory Turnover is a ratio that measures a company’s ability to manage its inventory efficiently by calculating the number of times during a period that a company’s inventory is sold and replaced.

Accounts Receivable Turnover is a ratio that measures a company’s ability to manage its accounts receivable efficiently by calculating the number of times during a period that a company’s accounts receivable are collected.

Asset Turnover is a ratio that measures a company’s ability to manage its assets efficiently by calculating the total sales divided by the total assets.

Solvency Ratios

Solvency ratios measure a company’s ability to meet its long-term financial obligations. Examples include the debt to equity ratio and the debt to assets ratio.

Debt to Equity Ratio is a ratio that measures a company’s financial leverage by calculating the total liabilities divided by the total shareholders’ equity.

Debt to Assets Ratio is a ratio that measures a company’s financial leverage by calculating the total liabilities divided by the total assets.

Valuation Ratios

Valuation ratios measure a company’s stock price in relation to its earnings. Examples include the price-to-earnings ratio, the price-to-book ratio, and the dividend yield.

Price-to-Earnings Ratio is a ratio that measures the stock price in relation to the company’s earnings by calculating the current stock price divided by the earnings per share.

Price-to-Book Ratio is a ratio that measures the stock price in relation to the company’s book value by calculating the current stock price divided by the book value per share.

Dividend Yield is a ratio that measures the stock price in relation to the company’s dividend payments by calculating the annualized dividend divided by the current stock price.

These are the major categories of financial ratios used to analyze the financial performance, liquidity, and profitability of a company. By understanding the different types of financial ratios, investors can gain valuable insights into a company’s financial health and make better investment decisions.