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What are the five categories of financial ratios and what does each measure?

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Question: What are the five categories of financial ratios and what does each measure?
Answer:

Financial ratios can be divided into five categories:

  • Liquidity (Solvency) ratios
  • Financial Leverage (Debt) ratios
  • Asset Efficiency (Management or turnover) ratios
  • Profitability ratios
  • Market value ratios
  • The liquidity or solvency ratios focus on a firm's ability to pay its short-term debt obligations. As such, they focus on the firm's current assets and current liabilities on the balance sheet.

    The most common liquidity ratios are the current ratio, the quick ratio, and the burn rate (interval measure).

    The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. It looks at the firm's long term liabilities on the balance sheet such as bonds.

    The most common financial leverage ratios are the total debt ratios, the debt/equity ratio, the long-term debt ratio, the times interest earned ratio, the fixed charge coverage ratio, and the cash coverage ratio.

    The asset efficiency or turnover ratios measure the efficiency with which the firm uses its assets to produce sales. As a result, it focuses on both the income statement (sales) and the balance sheet (assets).

    The most common asset efficiency ratios are the inventory turnover ratio, the receivables turnover ratio, the days' sales in inventory ratio, the days' sales in receivables ratio, the net working capital ratio, the fixed asset turnover ratio, and the total asset turnover ratio.

    The profitability ratios are just what the name implies. They focus on the firm's ability to generate a profit and an adequate return on assets and equity. They measure how efficiently the firm uses its assets and how effectively it manages its operations.

    The market value ratios can only be calculated for publicly traded companies as they relate to stock price. The most commonly used market value ratios are the price/earnings ratio and the market-to-book ratio.

    These ratios allow you to compare your firm to others in your industry. They also allow you to compare different time periods of data for your firm to each other.

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