Financial ratios are a way to gauge the strength, profitability, efficiency, and quality of a business from a variety of different angle, as well as monitor changes in the business over time. It's important that you memorize the most important of these, and it helps to remember that they tend to fall under five major categories.
Leverage Financial Ratios
Those financial ratios that show the percentage of a company’s capital structure that is made up on debt or liabilities owed to external parties
Liquidity Financial Ratios
Those financial ratios
that show the solvency of a company based on its assets versus its liabilities. In other words, it lets you know the resources available for a firm to use in order to pay its bills, keep the lights on, and pay the staff.
Operating Financial Ratios
These financial ratios show the efficiency of management and a company’s operations in utilizing its capital. In the retail industry, this would include metrics such as inventory turnover
, accounts receivable turnover
Profitability Financial Ratios
These financial ratios measure the return earned on a company’s capital and the financial cushion relative to each dollar of sales. A firm that has high gross profit margins
, for instance, is going to be much harder to put out of business when the economy turns down than one that has razor-thin margins. Likewise, a company with high returns on capital
, even with smaller margins, is going to have a better chance of survival because it is so much more profitable relative to the shareholders’ contributed investment.
Solvency Financial Ratios
These financial ratios tell you the chances of a company going bankrupt. There’s really no elegant way to say that. The whole point of calculating them is to make sure that a company isn’t in danger of going under anytime soon.