Financial Ratios

In identifying four types of financial ratios it is important to keep in mind that ratios are only meaningful when compared to other ratios set by standards of a particular entity. There are five categories of financial ratios; liquidity helps a company analyze their ability to meet short-term obligations, activity analyzes how quickly assets can be turned into cash or sales, profitability helps to analyze management's ability to control expenses and earn money through company resources, debt helps measure the effect of borrowed funds for company financing (CSUL, 2007), and market which helps investors decide how the firm is doing. (Gitman, 2006) All ratios are derived from easy calculated formulas using basic math skills.

Under each category fall specific ratios of which I will identify four stating what they can tell you about a company. The first ratio is Current ratio=Current assets/Current liabilities. This ratio lies in the liquidity category. It measures the firm's ability to pay debts. (CSUL, 2007) Using this ratio helps the firm to measure how much working capitol they have. For example a current ratio of 1:1 means they have no working capital. Next is Gross Profit Margin=Sales-Costs of goods sold/Sales. This ratio falls in the profitability category. It shows the profitability of sales after the costs of sales has been deducted. (CSUL, 2007) This ratio is important to the firm in order for the firm compare how much gross profit they are making and may help them come up with new ideas to increase sales or discover why sales have decreased. Then there is Total Asset Turnover=Sales/Total assets. This ratio measures how effectively a company uses its total resources to generate sales. (CSUL, 2007) For any company this ratio helps in deciding whether the company's "operations have been financially effective." (Gitman, pg.62, 2006) One can see why this falls in the category of activity. The last ratio is in the debt category. This ratio is Debt Ratio=Total debt/Total assets. This ratio assists in letting a firm know how much of its assets have been financed using borrowed funds. (CSUL, 2007) For the firm this is important to let them see how much financial leverage they hold.

Financial ratios should be used as indicators showing where strengths and weaknesses lie. This is important to any bank or investor because it reveals if the company is likely to become profitable.