Which group of ratios measure how effectively a firm is using its assets?
Financial ratio analysis uses the data contained in financial documents like the balance sheet and statement of cash flows to assess a business's financial strength. These financial ratios help business owners and average investors assess profitability, solvency, efficiency, coverage, market value, and more. Show
Key Takeaways
What Is Financial Ratio Analysis?Financial ratios are useful tools that help business managers, owners, and potential investors analyze and compare financial health. They are one tool that makes financial analysis possible across a firm's history, an industry, or a business sector. Financial ratio analysis uses the data gathered from these ratios to make decisions about improving a firm's profitability, solvency, and liquidity. Types of Financial RatiosThere are six categories of financial ratios that business managers normally use in their analysis. Within these six categories are multiple financial ratios that help a business manager and outside investors analyze the financial health of the firm. NoteIt's important to note that financial ratios are only meaningful in comparison to other ratios for different time periods within the firm. They can also be used for comparison to the same ratios in other industries, for other similar firms, or for the business sector. Liquidity RatiosThe liquidity ratios answer the question of whether a business firm can meet its current debt obligations with its current assets. There are three major liquidity ratios that business managers look at:
Efficiency RatiosEfficiency ratios, also called asset management ratios or activity ratios, are used to determine how efficiently the business firm is using its assets to generate sales and maximize profit or shareholder wealth. They measure how efficient the firm's operations are internally and in the short term. The four most commonly used efficiency ratios calculated from information from the balance sheet and income statement are:
Solvency RatiosA business firm's solvency, or debt management, ratios allow the analyst to appraise the position of the business firm's debt financing or financial leverage that they use to finance their operations. The solvency ratios gauge how much debt financing the firm uses as compared to either its retained earnings or equity financing. There are two major solvency ratios:
Coverage RatiosThe coverage ratios measure the extent to which a business firm can cover its debt obligations and meet the associated costs. Those obligations include interest expenses, lease payments, and, sometimes, dividend payments. These ratios work with the solvency ratios to give a financial manager a full picture of the firm's debt position. Here are the two major coverage ratios:
Profitability RatiosProfitability ratios are the summary ratios for the business firm. When profitability ratios are calculated, they sum up the effects of liquidity management, asset management, and debt management on the firm. The four most common and important profitability ratios are:
Market Value RatiosMarket Value Ratios are usually calculated for publicly held firms and are not widely used for very small businesses. Some small businesses are, however, traded publicly. There are three primary market value ratios:
How Does Financial Ratio Analysis Work?Financial ratio analysis is used to extract information from the firm's financial statements that can't be evaluated simply from examining those statements. Ratios are generally calculated for either a quarter or a year. NoteTo calculate financial ratios, an analyst gathers the firm's balance sheet, income statement, and statement of cash flows, along with stock price information if the firm is publicly traded. Usually, this information is downloaded to a spreadsheet program. Small businesses can set up their spreadsheet to automatically calculate each of these financial ratios. Interpretation of Financial Ratio AnalysisOne ratio calculation doesn't offer much information on its own. Financial ratios are only valuable if there is a basis of comparison for them. Each ratio should be compared to past periods of data for the business. The ratios can also be compared to data from other companies in the industry. It is only after comparing the financial ratios to other time periods and to the companies' ratios in the industry that an analyst can draw conclusions about the firm performance. For example, if a firm's debt-to-asset ratio for one time period is 50%, that doesn't tell a useful story unless it's compared to previous periods, especially if the debt-to-asset ratio was much lower or higher historically. In this scenario, the debt-to-asset ratio shows that 50% of the firm's assets are financed by debt. The financial manager or an investor wouldn't know if that is good or bad unless they compare it to the same ratio from previous company history or to the firm's competitors. NotePerforming an accurate financial ratio analysis and comparison helps companies gain insight into their financial position so that they can make necessary financial adjustments to enhance their financial performance. There are other financial analysis techniques that owners and potential investors can combine with financial ratios to add to the insights gained. These include analyses such as common size analysis and a more in-depth analysis of the statement of cash flows. Who Uses Financial Ratio Analysis?Several stakeholders might need to use financial ratio analysis:
Frequently Asked Questions (FAQs)What are 5 key financial ratios?Five of the most important financial ratios for new investors include the price-to-earnings ratio, the current ratio, return on equity, the inventory turnover ratio, and the operating margin. Why is financial ratio analysis important?Financial ratio analysis quickly gives you insight into a company's financial health. Rather than having to look at raw revenue and expense data, owners and potential investors can simply look up financial ratios that summarize the information they want to learn. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning! Was this page helpful? Thanks for your feedback! Tell us why! Other SubmitSources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
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