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The Basics of Financial Ratios


Financial ratios are a tool used by businesses and investors to measure and evaluate various aspects of a company's financial performance and health. They are calculated by dividing one financial metric by another, and they provide insights into a company's profitability, efficiency, liquidity, and solvency.




Key Ratios


There are many different financial ratios that can be used, but some of the most commonly used ratios include:


1. Current ratio: This measures the ability of a business to pay its short-term debts using its current assets. It is calculated by dividing current assets by current liabilities.


2. Quick ratio: This is similar to the current ratio, but it excludes inventory from current assets. It is calculated by dividing current assets (excluding inventory) by current liabilities.


3. Debt-to-equity ratio: This measures the amount of debt a business has relative to its equity. It is calculated by dividing total liabilities by total equity.


4. Return on assets (ROA): This measures the profitability of a business relative to its assets. It is calculated by dividing net income by total assets.


5. Return on equity (ROE): This measures the profitability of a business relative to its equity. It is calculated by dividing net income by total equity.


6. Gross margin: This measures the profitability of a business after taking into account the cost of goods sold. It is calculated by dividing gross profit by total revenue.


7. Operating margin: This measures the profitability of a business after taking into account the cost of goods sold and operating expenses. It is calculated by dividing operating profit by total revenue.


8. Net margin: This measures the profitability of a business after taking into account the cost of goods sold, operating expenses, and taxes. It is calculated by dividing net income by total revenue.


9. Asset turnover: This measures the efficiency with which a business is using its assets to generate revenue. It is calculated by dividing total revenue by total assets.


10. Inventory turnover: This measures the number of times a business's inventory is sold and replaced over a period of time. It is calculated by dividing the cost of goods sold by average inventory.


11. Days sales outstanding (DSO): This measures the average number of days it takes a business to collect payment from its customers. It is calculated by dividing accounts receivable by average daily sales.


12. Fixed-asset turnover: This measures the efficiency with which a business is using its fixed assets (such as buildings and equipment) to generate revenue. It is calculated by dividing total revenue by total fixed assets.


13. Total debt ratio: This measures the proportion of a business's assets that are financed through debt. It is calculated by dividing total debt by total assets.


14. Times interest earned (TIE): This measures a business's ability to meet its interest payments on its debts. It is calculated by dividing earnings before interest and taxes by interest expense.

Ratio Benchmarks are Different Across Industries


Financial ratios can vary significantly across industries. Different industries have different characteristics and face different types of risks, which can affect their financial performance and the way they are evaluated. For example, a company in the retail industry may have different financial ratios compared to a company in the healthcare industry because the two industries have different operating environments, business models, and financial drivers.

For instance, a company in the retail industry may have a high inventory turnover ratio because it is selling a large volume of goods and replenishing its inventory frequently. In contrast, a company in the healthcare industry may have a lower inventory turnover ratio because it is not selling goods in the same way as a retail company.


It is important to compare a company's financial ratios to those of its peers within the same industry to get a more accurate understanding of its financial performance. This is because financial ratios can provide a useful benchmark for comparing a company's performance to that of its peers and can help identify potential strengths and weaknesses.


Conclusion


Financial ratios are useful for a variety of purposes, including comparing a company's performance to industry benchmarks, evaluating the risk of investing in a company, and identifying areas for improvement within a company. However, it's important to keep in mind that financial ratios should be used in conjunction with other financial analysis tools and should be considered in the context of the specific industry and market in which a company operates.

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