Financial Ratios

Introduction

Investors and other external users of financial information will often need to measure the performance and financial health of an organization. This is done in order to evaluate the success of the business, determine any weaknesses of the business, compare current and past performance, and compare current performance with industry standards. Financially stable organizations are desirable, because a financially stable business is one that successfully ensures its ability to generate income for investors and retain or increase value.

There are many different methods that can be used alone or together to help investors assess the financial stability of an organization. One of the most common methods is financial ratio analysis. The basic ratios include five categories: profitability ratios, liquidity ratios, debt ratios, and asset activity ratios.

Profitability Ratios

Profitability ratios measure the profitability of the organization. They include the gross profit margin, operating profit margin, net profit margin, the return on assets (ROA) ratio, and the return on equity (ROE) ratio.

The gross profit margin is calculated by taking the amount of gross profit and dividing it by sales. This ratio is used to determine the amount of profit remaining from each sales dollar after subtracting the cost of goods sold. Example: a gross profit margin of 0.05 indicates that 5% of sales revenue is left to use for purposes other than the cost of goods sold.

The operating profit margin is calculated by taking earnings before income and taxes and dividing it by sales. This ratio is used to determine how effective the company is at keeping production costs low. Example: an operating profit margin of 0.17 indicates that after subtracting all operating expenses 17% of sales revenues remain.

The net profit margin is calculated by taking the net earnings available to common stockholders and dividing it by sales. This ratio is used to determine the amount of net profit for each dollar of sales that remains after subtracting all expenses. Example: a net profit margin of 0.084 indicates that 8.4% of each sales dollar remains after all expenses are paid.

The ROA ratio is calculated by taking the net earnings available to common stockholders (net income) and dividing it by total assets. This ratio is used to determine the amount of income each dollar of assets generates. Example: an ROA ratio of 0.0568 indicates that each dollar of company assets produced income of almost $0.06.

The ROE ratio is calculated by taking the net earnings available to common stockholders and dividing it by common stockholders' equity. This ratio is used to determine the amount of income produced for each dollar that common stockholders have invested. Example: An ROE ratio of 0.0869 indicates that the company returned 8.69% for every dollar invested by common stockholders.

Liquidity Ratios

Liquidity ratios measure the organizations ability to meet short-term obligations. These include the current ratio and the quick ratio.

The current ratio is calculated by taking the total amount of current assets and dividing it by the total amount of current liabilities. This ratio is used to determine whether the company has a sufficient amount of current assets to pay off current liabilities. Example: a current ratio of 2.57 indicates that the company has $2.57 worth of current assets for every $1.00 of current liabilities.

The quick ratio is calculated by taking the total amount of current assets less inventory and dividing it by the total amount of current liabilities. This ratio is used to determine the company's ability to repay current liabilities after the least liquid of its current assets is removed from the equation. Example: a quick ratio of 2.48 indicates that the company could pay off 248% of its current liabilities by liquidating all current assets other than inventory.

Debt Ratios

Debt ratios measure the amount of debt an organization is using and the ability of the