Financial ratios measure how well a business is doing. They show if a business is making money, paying its bills on time, and using its resources wisely. These numbers help business owners, banks, and investors decide if a company is financially strong or struggling.
Liquidity Ratios – Can a Business Pay Its Short-Term Bills?
Liquidity ratios show if a company has enough money to pay its bills on time. A business with strong liquidity can cover short-term expenses without borrowing.
- Current Ratio – Compares a company’s available money and valuable items (such as cash, products, and customer payments) to its short-term debts (such as rent, salaries, and supplier payments). A higher number means the company can easily pay its bills.
- Quick Ratio (Acid-Test Ratio) – Similar to the current ratio, but it does not include products the company sells. It only counts money that can be used immediately.
- Accounts Receivable Turnover – Measures how fast a company collects money from customers who buy on credit (pay later). A high number means customers pay quickly, which is a good sign.
- Inventory Turnover – Shows how often a company sells and replaces its products. A high number means products are selling quickly. A low number may mean products are not selling well.
Profitability Ratios – Is the Business Making Enough Money?
Profitability ratios measure if a company is earning more than it spends. A business that makes a good profit can grow and stay successful.
- Profit Margin – Shows how much of a company’s sales become profit after paying for expenses.
- Example: If a bakery sells a cake for $20 and spends $15 on ingredients, rent, and wages, the profit is $5. The profit margin is 25%.
- Asset Turnover – Measures how well a company uses what it owns (such as buildings, machines, and inventory) to make money. A high number means the business is using its resources well.
- Return on Assets (ROA) – Shows how much profit a company makes for every dollar it owns. A higher number means the company is using its money wisely.
- Return on Equity – Measures how much profit a company makes compared to the money invested by its owners. A high number means better returns for investors.
- Earnings Per Share (EPS) – Tells how much profit each share of company stock earns. If EPS is increasing, the company is becoming more valuable.
- Price-to-Earnings (P/E) Ratio – Compares a company’s stock price to its earnings. A high P/E ratio means people believe the company will grow in the future.
- Payout Ratio – Shows how much of a company’s profit is paid to investors and how much is kept to help the business grow.
Solvency Ratios – Can a Business Pay Its Long-Term Debts?
Solvency ratios measure if a company can pay its debts over time. A company with good solvency is less likely to have financial problems.
- Debt to Total Assets Ratio – Shows how much of a company’s money and property comes from borrowed money. A low number means the company does not depend too much on loans.
- Example: If a company owns $1 million in buildings, equipment, and cash, and owes $400,000 in loans, the ratio is 40%. This means 40% of what the company owns was paid for with borrowed money.
- Times Interest Earned – Measures how easily a company can pay the interest on its loans. A high number means the company earns enough money to handle its debts.
Conclusion
Financial ratios help businesses and investors understand if a company is doing well. Liquidity ratios check if a company can pay short-term bills, profitability ratios show if it is making money, and solvency ratios measure if it can handle long-term debts. Understanding these numbers helps businesses make better financial decisions and plan for the future.