Financial ratios have two primary users, investors and management. Management uses financial ratios to determine how well their firm is performing in order to evaluate where the firm can improve. For example, if a firm has a low gross margin, a manager can evaluate how to increase their gross margin. Investors use financial ratios to see if the firm is a good investment. By comparing financial ratios between companies and between industries, investors can better determine the best investment.
Liquidity ratios deal with a firm's short-term financing and debt. By being liquid, a firm is quickly able to convert assets to cash, and pay off interest. The main liquidity ratios are the current ratio and quick ratio.
Leverage ratios involve the amount of debt used to finance a firm's assets. A firm can finance through debt or equity. The firm must eventually pay back debt, while equity is an investment in the company. The main leverage ratios are debt to equity ratio and long-term debt to capitalization ratio.
Operational ratios show a firm's performance. For example, accounts receivable turnover ratio shows the firm's performance in collecting accounts receivable. Inventory turnover ratio shows a firm's performance in converting inventory into cost of goods sold.
Profitability ratios show the return on sales and the profitability of the firm. The main profitability ratios are return on assets, return on equity and return on capital employed.
Solvency ratios show the firm's ability to pay off debt through cash flows. The main solvency ratio is the solvency ratio. The solvency ratio divides net tax profit plus depreciation by short-term liabilities plus long-term liabilities. A general rule of thumb is that a solvency ratio of about 20 percent is healthy.
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