Question

There are several types of financial ratios. The most common include; liquidity ratios, profitability ratios, solvency ratios, and activity ratios. What does each category measure? Give an example of each.

Answer 1

Liquidity ratios:
The liquidity ratios measures the ability of a company to pay off its short term liabilities.
Example: Current ratio=Current assets/Current liabilities
If the value of current ratio is more than 1, it means the company has greater ability to pay off its short term liabilities.
If the value of current ratio is less than 1, it means that the company will face difficulties in paying of its short term liabilities as the current liabilities are more than current assets.

Profitability ratios:
It measures how efficient a firm is in converting the business activities into profit. It measures the potential of a firm to generate profits relative to the revenue. Higher value of profitability ratios are preferred.
Example: Profit margin ratio=Net income/Net Sales
It measures how much profit or net income is generated by a company at a given sales level.

Solvency ratios:
It measures the ability of a company to meet its debt obligations.
Example: Debt/Asset ratio=Total Debt/Total Assets.
Lower values of solvency ratios are preferred. A ratio greater than 1 would mean that the value of total debt is higher than total assets, this would make a company more prone to downturns during business cycles.

Activity ratios:
Measures how effectively a firm converts its assets, capital, and other accounts in its balance sheet to sales or cash.
Example: Total asset turnover ratio=Total sales/Average total assets.
Higher value of asset turnover ratio is preferred, higher ratio shows better efficiency of a company.