Various Types of Ratios in Financial Ratio Analysis

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Analysts use financial ratios to get an idea about a company’s performance and compare its performance to that of other companies in the industry. Looking into a company’s financial statements and financial ratios provides a picture of how well the company is doing at a certain point of time.

Liquidity Ratios

These ratios provide an idea about well a company is situated to meet its current liabilities. Investors get this information by comparing a company’s current assets with its current liabilities. If the company has an adequate level of assets to pay its liabilities, that is a positive sign. Analysts consider a liquidity ratio of two to be healthy since it indicates that the company has enough assets on hand to meet its current liabilities. If the company does not have adequate assets to meet its upcoming liabilities, investors should investigate further.

Leverage Ratios

These ratios give an idea about how much debt a company has on its books. If the company uses its debt to generate better earnings for shareholders, analysts view use of debt positively. One common leverage ratio, the debt-to-equity ratio, looks at a company’s debt levels and compares that to the company’s equity. Another way of looking at leverage is to get an idea about how much money a company has available to meet its interest payment obligations. It is a healthy sign if a company has enough money on hand to meet its interest payment commitments. On the other hand, it is a bad sign if a company is not generating adequate earnings to cover its debt servicing.

Profitability Ratios

The purpose for a company’s existence is to make a profit for its shareholders. It is important to see how well the company is doing in this respect. The ratios that provide this input are grouped together as profitability ratios. The gross profit margin measures what sort of profit a company is generating from its sales after deducting the cost of the goods sold. It is a basic ratio that does not take into account other costs that companies incur. Return on equity is another profitability ratio that measures how much of a return the company is getting on the equity it has invested. This ratio is generated by dividing a company’s earnings by the total shareholder’s equity invested in the business. This gives investors an idea about how profitable a company is too. It is not easy to standardize profitability ratios since profits vary from one industry to another.