Which type of financial ratio indicates whether or not the organization is capable of paying off its short

The use of financial figures to gain significant information about a company

Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.

Financial ratios are grouped into the following categories:

Liquidity ratios
Leverage ratios
Efficiency ratios
Profitability ratios
Market value ratios

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the company:

External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
Internal users: Management team, employees, and owners

Liquidity Ratios

Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:

The current ratio measures a company’s ability to pay off short-term liabilities with current assets:

Current ratio = Current assets / Current liabilities

The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:

Acid-test ratio = Current assets – Inventories / Current liabilities

The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:

Cash ratio = Cash and Cash equivalents / Current Liabilities

The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

Leverage Financial Ratios

Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:

The debt ratio measures the relative amount of a company’s assets that are provided from debt:

Debt ratio = Total liabilities / Total assets

The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratio shows how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio reveals how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Efficiency Ratios

Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:

The asset turnover ratio measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Average total assets

The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

The days sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Profitability Ratios

Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following:

The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency:

Operating margin ratio = Operating income / Net sales

The return on assets ratio measures how efficiently a company is using its assets to generate profit:

Return on assets ratio = Net income / Total assets

The return on equity ratio measures how efficiently a company is using its equity to generate profit:

Return on equity ratio = Net income / Shareholder’s equity

Learn more about the different profitability ratios in the following video:

Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following:

The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding

The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for each share outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share

Thank you for reading CFI’s guide to financial ratios. To help you advance your career in the financial services industry, check out the following additional CFI resources:

While you may not have a background in finance, a basic understanding of the key concepts of financial accounting can help you improve your decision-making process, as well as your chances for career success. With a better understanding of how your organization measures financial performance, you can take steps to provide additional value in your daily activities.

Finance can be intimidating for the uninitiated. To help you become more comfortable understanding and speaking about financial topics, here’s a list of the top financial metrics managers need to understand.

What Are Financial KPIs?

Financial KPIs (key performance indicators) are metrics organizations use to track, measure, and analyze the financial health of the company. These financial KPIs fall under a variety of categories, including profitability, liquidity, solvency, efficiency, and valuation.

By understanding these metrics, you can be better positioned to know how the business is performing from a financial perspective. You can then use this knowledge to adjust the goals of your department or team and contribute to critical strategic objectives.

For managers, these metrics and KPIs should be made available internally and distributed on a weekly or monthly basis in the form of email updates, dashboards, or reports. If they’re not readily distributed, you can still become familiar with the metrics via financial statement analysis.

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What Is Financial Statement Analysis?

Financial statement analysis is the process of reviewing key financial documents to gain a better understanding of how the company is performing. While there are many different types of financial statements that can be analyzed as part of this process, some of the most important, especially to managers, include the:

Balance Sheet: A statement that lists a business’s assets, liabilities, and owners’ equity at a specific point in time.
Income Statement: A statement that summarizes a business’s revenues, expenses, and profits over a period.
Cash Flow Statement: A statement that captures how cash flow is affected by activities from the balance sheet and income statement, categorized into operating, investing, and financing activities.
Annual Report: A document that describes the company’s operations and financial conditions, and typically includes the documents listed above, in addition to other insights and narrative from key figures within the company.

13 Financial Performance Measures to Monitor

The metrics below are typically found in the financial statements listed above and among the most important for managers and other key stakeholders within an organization to understand.

1. Gross Profit Margin

Gross profit margin is a profitability ratio that measures what percentage of revenue is left after subtracting the cost of goods sold. The cost of goods sold refers to the direct cost of production and does not include operating expenses, interest, or taxes. In other words, gross profit margin is a measure of profitability, specifically for a product or item line, without accounting for overheads.

Gross Profit Margin = (Revenue - Cost of Sales) / Revenue * 100

2. Net Profit Margin

Net profit margin is a profitability ratio that measures what percentage of revenue and other income is left after subtracting all costs for the business, including costs of goods sold, operating expenses, interest, and taxes. Net profit margin differs from gross profit margin as a measure of profitability for the business in general, taking into account not only the cost of goods sold, but all other related expenses.

Net Profit Margin = Net Profit / Revenue * 100

3. Working Capital

Working capital is a measure of the business’s available operating liquidity, which can be used to fund day-to-day operations.

Working Capital = Current Assets - Current Liabilities

4. Current Ratio

Current ratio is a liquidity ratio that helps you understand whether the business can pay its short-term obligations—that is, obligations due within one year— with its current assets and liabilities.

Current Ratio = Current Assets / Current Liabilities

5. Quick Ratio

The quick ratio, also known as an acid test ratio, is another type of liquidity ratio that measures a business’s ability to handle short-term obligations. The quick ratio uses only highly liquid current assets, such as cash, marketable securities, and accounts receivables, in its numerator. The assumption is that certain current assets, like inventory, are not necessarily easy to turn into cash.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

6. Leverage

Financial leverage, also known as the equity multiplier, refers to the use of debt to buy assets. If all the assets are financed by equity, the multiplier is one. As debt increases, the multiplier increases from one, demonstrating the leverage impact of the debt and, ultimately, increasing the risk of the business.

Leverage = Total Assets / Total Equity

7. Debt-to-Equity Ratio

The debt-to-equity ratio is a solvency ratio that measures how much a company finances itself using equity versus debt. This ratio provides insight into the solvency of the business by reflecting the ability of shareholder equity to cover all debt in the event of a business downturn.

Debt to Equity Ratio = Total Debt / Total Equity

8. Inventory Turnover

Inventory turnover is an efficiency ratio that measures how many times per accounting period the company sold its entire inventory. It gives insight into whether a company has excessive inventory relative to its sales levels.

Inventory Turnover = Cost of Sales / (Beginning Inventory + Ending Inventory / 2)

9. Total Asset Turnover

Total asset turnover is an efficiency ratio that measures how efficiently a company uses its assets to generate revenue. The higher the turnover ratio, the better the performance of the company.

Total Asset Turnover = Revenue / (Beginning Total Assets + Ending Total Assets / 2)

10. Return on Equity

Return on equity, more commonly displayed as ROE, is a profitability ratio measured by dividing net profit over shareholders’ equity. It indicates how well the business can utilize equity investments to earn profit for investors.

ROE = Net Profit / (Beginning Equity + Ending Equity) / 2

11. Return on Assets

Return on assets, or ROA, is another profitability ratio, similar to ROE, which is measured by dividing net profit by the company’s average assets. It’s an indicator of how well the company is managing its available resources and assets to net higher profits.

ROA = Net Profit / (Beginning Total Assets + Ending Total Assets) / 2

12. Operating Cash Flow

Operating cash flow is a measure of how much cash the business has as a result of its operations. This measure could be positive, meaning cash is available to grow operations, or negative, meaning additional financing would be required to maintain current operations. The operating cash flow is usually found on the cash flow statement and can be calculated using one of two methods: direct or indirect.

13. Seasonality

Seasonality is a measure of how the period of the year is affecting your company’s financial numbers and outcomes. If you’re in an industry that’s affected by high and low seasons, this measure will help you sort out confounding variables and see the numbers for what they truly are.

It’s important to note there’s no absolute good or bad when it comes to financial KPIs. Metrics need to be compared to prior years or competitors in the industry to see whether your company’s financial performance is improving or declining and how it’s performing relative to others.

The Bottom Line

There are many other financial KPIs you can track and monitor to understand how your company is doing and how your actions impact progress toward shared goals. The financial KPIs listed above are a great place to start if you’re unfamiliar with finance. Understanding how these metrics influence business strategy is a critical financial accounting skill for all managers to develop.

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