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Classification of Ratios

One of the ways in which financial statements can be put to work is through ratio analysis. Ratios are simply one number divided by another; as such they may or may not be meaningful. In finance, ratios are usually two financial statement items that may be related to one another and may provide the prudent user a good deal of information.

Of the myriad of ratios that could be generated, some will be more meaningful than others. Generally, ratios are divided into four areas of classification that provide different kinds of information: liquidityturnoverprofitability, and debt.

  • Liquidity ratios indicate a firm’s ability to meet its maturing short-term obligations.
  • Turnover indicates how effectively a firm manages resources at its disposal to generate sales.
  • Profitability indicates the efficiency with which a firm manages resources.
  • Debt indicates the extent to which a firm is financed by debt.

Liquidity Ratios

Click below to read more about the common liquidity ratios:

Turnover Ratios

Click below to read more about the common turnover ratios:

Profitability Ratios

Click below to read more about the common profitability ratios:

Debt Ratios

Click below to read more about the common debt ratios:

Evaluations

Remember, ratios are just one number divided by another and as such really don’t mean much. The trick is in the way ratios are analyzed and used by the decision-maker. A good strategy is to compare ratios to some sort of benchmark, such as industry averages, to what a company has done in the past, or both.

Comparisons

Once ratios are calculated, an analyst needs some benchmarks to find out where the company stands at that particular point. Useful benchmarks are industry comparisons and company trends.

It may be useful to compare a company to certain industry averages to get a feel for how the company is performing. In this case, it is necessary to obtain industry performance measures. There are a number of sources for industry figures.

  • Commercial Sources – A number of companies publish information on industry comparisons. Among these sources are private credit reporting agencies such as Dun & Bradstreet and RMA – The Risk Management Association. Rating agencies such as Moody’s and Standard & Poor’s also provide industry information.
  • Government Sources – There are a number of government sources of helpful industry information, such as the U.S. Industrial Outlook and Quarterly Financial Reports.
  • Trade Associations – Many industries have trade associations or industry groups that regularly publish information for and about members.

This overview was developed by Dr. Sharon Garrison.
No adaptation of its content is permitted without permission.

FAQs

1. What is ratio analysis?

Ratio analysis is a quantitative method of gaining insight into the financial condition of a company. In finance, ratios are usually two financial statement items that may be related to one another and may provide important insights.

2. What does ratio analysis tell you?

Ratio analysis compares line-item data from a company's financial statements in order to identify trends, relationships and potential problems.

3. What are the types of ratio analysis?

There are four main types of ratios: liquidity, turnover, profitability and debt.

Liquidity ratios indicate a company's ability to meet its maturing short-term obligations. Turnover ratios indicate how effectively a company manages its resources to generate sales. Profitability ratios indicate the efficiency with which a company is managed. Debt ratios indicate the extent to which a company is financed by debt.

4. What is the importance of ratio analysis?

Ratio analysis is important because it provides a snapshot of a company's financial condition and allows for comparisons to be made between companies, industries and/or time periods.

Let's say you are the owner of a company. You may use ratios to compare your company's performance to industry averages or to the performance of your own company in past years. This can help you to identify areas where your company is doing well and areas where it could improve. If you own a business, it's likely you need a 401(k) plan. Learn more about setting up a 401(k) plan for your company here.

5. What are the benefits of ratio analysis?

The benefits of ratio analysis include an improved understanding of a company's financial condition and how it compares to others, identification of trends, relationships and potential problems, and improved decision making.

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