How to Analyze Financial Ratios

by Steve Gregory

Analyzing the financial ratios of a business is necessary to determine its financial health and performance. The ratios are not only used by business owners to evaluate the current performance of their companies, they are also used by creditors and investors to determine if a business is financially sound. The data needed to calculate financial ratios are available in the financial statements of a business, such as its balance sheet. Each financial ratio is calculated by dividing one specific numerical value by another and the result can be a percentage or decimal value.

1. Analyze the liquidity ratios. These ratios measure the available cash that a company needs to cover its current and future debt. The degree of a company's liquidity can be affected by many factors, including seasonal trends and the company's age. However, a higher liquidity ratio in general demonstrates that a company is able to pay its debts on time, is a safe credit bet and does not invest too much capital in inventory. Quick ratio, current ratio, cash to total assets and cash of sales to payables are examples of liquidity ratios. An example of a positive current ratio is 2:1. The current ratio is a company's current assets divided by its current liabilities.

2. Evaluate the activity ratios. These ratios are also known as efficiency ratios and determine a company's ability to convert its resources and assets to cash. For example, a company's management can use these ratios to help determine if the inventory turnover rate is acceptable. The cost of goods sold for the year divided by the average inventory is an example of the annual inventory turnover activity ratio. This ratio measures a company's sales volume against its storage and distribution of goods. In this example, a high ratio is better than a low ratio because the company is not wasting capital by storing excess inventory. Inventory holding period and average collection period are other examples of activity ratios.

3. Analyze the leverage ratios. These ratios help to analyze a company's total liabilities and its ability to repay debt used to finance its daily operations. Leverage ratios are also called debt ratios because they are used by investors to determine if a company's debt will make it a bad investment. In general, the lower the average leverage ratio a company has, the lower the amount of debt is on its balance sheet. For example, a low fixed-to-worth leverage ratio is ideal for investors and creditors because it means that the amount of capital that a company has invested in fixed assets, such as storage facilities, is low. In this example, the low fixed to worth ratio is the net fixed assets of a company divided by its tangible net worth. The debt to equity ratio is another example of a leverage ratio that is considered positive if it is low.

4. Evaluate the profitability ratios. These ratios determine if a business is generating an acceptable return on investment based on its performance. These ratios are important because they not only tell potential investors if a company is a safe bet but also alert the management of the company if their performance managing the business needs to improved. Return on assets, gross profitability and net profitability are examples of three commonly used profitability ratios. In general, a higher profitability ratio means that a company is a good investment. For example, a high return-on-assets ratio means that management is effectively using the company's assets. A high gross profitability ratio means that the company is enjoying high sales margins.

5. Analyze the dividend policy ratios. If you are interested in investing in a company, but you want to know what the return on investment is before making a commitment, dividend policy ratios can help you to make an informed decision. These ratios give a potential investor insight into a company's dividend yield and potential for future returns. A high payout ratio and/or dividend yield ratio is a factor that can determine a company's positive future rate of return for current investments. The payout ratio is a company's dividends per share divided by its earnings per share. The dividend yield is the dividends per share divided by the company's share price. In general, invest in companies that have high dividend policy ratios.

About the Author

An avid technology enthusiast, Steve Gregory has been writing professionally since 2002. With more than 10 years of experience as a network administrator, Gregory holds an Information Management certificate from the University of Maryland and is pursuing MCSE certification. His work has appeared in numerous online publications, including Chron and GlobalPost.

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