Question

What are the major classifications of ratios? What then do these major classifications represent.
- In YOUR VIEW if you could pick only three ratios to use to analyze a company what three would YOU choose and why....

Answer 1

Financial ratios are largely classified as :

1. Liquidity ratio includes current ratio, quick ratio, cash ratio. This type of ratios helps to understand the company's ability to pay the short term liabilities.

2. Activity ratio includes inventory turnover, receivables turnover, payables turnover, fixed asset turnover, total asset turnover. This type of ratios helps to understand the company's efficiency and to understand how the company uses the resources available

3. Leverage ratio includes debt equity ratio, interest coverage ratio. These ratios help to know the company's ability to pay the long term liability.

4. Profitability ratio includes gross profit margin, operating profit margin, net profit margin, return on asset, return on equity. These ratios tell about the company's profit and return on investment

5. Valuation includes P/E, EV/EBITDA, P/B, EV / Sales. These ratios help to know how under-valued and over-valued the company as compared to the industry peers

To analyse the company the three ratios I would prefer are Return on Equity, Interest Coverage Ratio and Working capital turnover

Return on Equity helps to know the how the return generated by the company on the equity invested by shareholders and hence, helps to understand the how profitable the company is

Interest Coverage ratio helps to understand how levered the company is and its capability to pay the interest payment using operating profit. This ratio can be useful when the default rates in the sector are usually high

Working capital turnover helps to understand how better the cash is managed in the company. It may be possible that the company's growth would be good, however, the company might be having high receivables or high inventory. This will result in less operating cash and hence, cash would not be growing as the revenue.