Question

Discuss the various categories of financial ratios used in financial statement analysis. Provide at least two examples of each type of ratio and discuss what the particular ratio tells us about the performance of a company. (Essay question)

Answer 1

There are broadly four types of financial ratios, liquidity ratios, leverage ratio, efficiency ratios, profitability ratios.

· Liquidity ratios: These ratios measure a firm ability to pay back its short-term debt like paying to suppliers and meeting its working capital requirement. The two main liquidity ratios are current ratio and quick ratio. Current ratio is simply current asset divided by current liability and measure as to how much times current asset is in terms of current liabilities. Quick ratio improves on the current ratio by removing the inventory and prepaid asset. There is another liquidity ratio called cash ratio, it is measured as cash and cash equivalent divided by current liability.

· Leverage ratio: Leverage ratio is a measure as to how much debt the company is carrying as a component of total asset. High leverage means the company is riskier. There are basically two main leverage ratio, total debt ratio which is calculated as total debt divided by total asset and debt to equity ratio which is calculated as long-term debt divided by equity.

· Efficiency ratio: Efficiency ratio is a measure of as to how efficiently the company is using its asset to generate return for the company shareholders. There are many types of efficiency ratios like asset turnover ratio, inventory turnover ratio, receivable turnover ratio, payable turnover ratio. Asset turnover ratio is calculated as sales divided by total asset, it measures how much is sales as a number of times of total asset. Inventory turnover ratio measures how many times the inventory is sold.

· Profitability ratios: Profitability ratio is a measure of how much profit the company has been able to generate. There are many types of profitability ratios like net profit margin, return on equity, return on asset etc. Net profit margin measures as to how much net profit is as percentage of sales. Return on equity measures as to how much return has been generated for the shareholders of the company.