Financial ratios compare the results in different line items of the financial statements. The analysis of these ratios is designed to draw conclusions regarding the financial performance, liquidity, leverage, and asset usage of a business. This type of analysis is widely used, since it is solely based on the information located in the financial statements, which is generally easy to obtain. In addition, the results can be compared to industry averages or to the results of benchmark companies, to see how a business is performing in comparison to other organizations.
The categories of financial ratios that are used for analysis purposes are as follows:
- Performance ratios. These ratios are derived from the revenue and aggregate expenses line items on the income statement, and measure the ability of a business to generate a profit. The most important of these ratios are the gross profit ratio and net profit ratio.
- Liquidity ratios. These ratios compare the line items in the balance sheet, and measure the ability of a business to pay its bills in a timely manner. Chief among these ratios are the current ratio and quick ratio, which compare certain current assets to current liabilities.
- Leverage and coverage ratios. These ratios are used to estimate the comparative amounts of debt, equity, and assets of a business, as well as its ability to pay off its debts. The most common of these ratios are the debt to equity ratio and the times interest earned ratio.
- Activity ratios. These ratios are used to calculate the speed with which assets and liabilities turn over, by comparing certain balance sheet and income statement line items. Rapid asset turnover implies a high level of operational excellence. The most common of these ratios are days sales outstanding, inventory turnover, and payables turnover.
Financial ratio analysis is only possible when a company constructs its financial statements in a consistent manner, so that the underlying general ledger accounts are always aggregated into the same line items in the financial statements. Otherwise, the provided information will vary from one period to the next, rendering long-term trend analysis useless.
