Smart investors use financial ratios to analyze a company&#039;s financial performance before making an investment. Financial ratios reveal how a company is financed, how it uses its resources, its ability to pay its debts and its ability to generate profit. Ratios provide a glimpse of a company&#039;s position at a particular time, and are most useful when compared across time periods and when comparing companies in the same industry. Ratios alone do not give a complete picture of a company&#039;s investment potential, but they are a wise place to start the analysis.
Liquidity ratios measure a firm&#039;s ability to pay its bills as they come due. Three commonly used liquidity ratios are the current ratio, the quick ratio and the cash ratio. The current ratio is found by dividing current assets by current liabilities. A ratio of 1 means the business has just enough current assets to pay current liabilities. Ratios above 1 mean a firm has more current assets than current liabilities; ratios below 1 mean more current liabilities than current assets. Investors typically prefer a lower current ratio because it shows that a firm&#039;s assets are working to grow the business.
The quick ratio, also called the acid test, subtracts inventory from current assets before dividing them by current liabilities. The acid test gives a more accurate view of the firm&#039;s short-term liquidity than the current ratio because it removes inventory that the firm may not be able to sell from the equation.
The cash ratio excludes all assets except cash and marketable securities such as stocks and bonds. It gives the best indication of a firm&#039;s ability to pay, should current creditors demand immediate payment.
Financial Leverage Ratios
Financial leverage ratios measure a firm&#039;s use of long-term debt. The debt ratio is total debt divided by total assets. A ratio above 1 means a firm has more debt than assets, below 1 means more assets than debt and 1 means equal debt and assets.
The debt-to-equity ratio divides total debt by total equity (the owner&#039;s investment). It indicates how a firm is financed. A ratio above 1 indicates the use of more debt than equity, while a ratio below 1 indicates the use of more equity. A high-debt firm is, all things being equal, weaker financially than one using more equity because it is more susceptible to interest rate increases. Investors generally prefer firms with lower debt.
Profitability ratios measure a firm&#039;s ability to generate profits. Gross profit margin, return on assets and return on equity are three commonly used ratios. Gross profit margin, also know as gross margin, indicates the percentage of net sales (sales minus cost of goods sold) going toward profit and fixed costs. Investors prefer high gross margins because they mean more money to cover fixed costs and more profit.
Return on assets reveals how well a firm uses its assets to generate income. It is found by dividing net income by total assets. Investors prefer a high return on assets.
Return on equity measures the return on each dollar invested in a firm&#039;s stock. It is found by dividing net income by shareholder equity. As with other profitability ratios, higher is better.
- accounts image by Alexey Klementiev from Fotolia.com