Common Business Ratios

Liquidity Ratios

Liquidity ratios provide answers to two specific questions: "How much cash does a firm have?" and "Are liquidity levels adequate to fund operating activities?" Simply put, the ratios indicate whether a firm has sufficient funds to finance its businesses over a period of time. The most common liquidity ratios include working capital, current ratio and cash ratio. Working capital gauges short-term cash availability and equals current assets minus current liabilities. Current ratio evaluates a firm's ability to pay short-term debts, such as accounts payable and taxes, with short-term assets (cash and accounts receivable, for example). Current ratio equals short-term assets divided by short-term debts. Cash ratio indicates a conservative view of a company's liquidity and estimates whether a firm has enough funds to survive under extreme conditions. Cash ratio equals cash plus short-term investments, such as stocks, divided by short-term liabilities.

Profitability indicators tell the rest the world a company's economic health as well as its revenue levels and short-term growth potential. Although various ratios indicate a firm's profitability, investors focus on net profit margin and return on equity when analyzing a firm's economic viability. Net profit margin equals net income divided by sales. Return on equity measures income that shareholders earned from their investments in a company. The ratio equals net income divided by equity capital.

Financial leverage ratios provide insight into a company's capital structure and indicate how corporate management funds long-term operating activities. Capital structure refers to the various sources of financing that a firm relies on to stay in business and expand. Common financial leverage ratios include total debts to assets and capitalization ratio. Total-debts-to-assets ratio indicates a firm's ability to absorb asset decreases resulting from losses without jeopardizing the interest of creditors. The ratio equals total debts divided by total assets. Capitalization ratio equals long-term debt divided by long-term debt plus owners' equity. The ratios indicates a company's long-term debt usage.

Efficiency ratios, such as cash turnover and accounts receivable turnover, indicate a firm's ability to generate profits from its resources. Cash turnover equals net sales divided by cash and measures how adeptly a company uses cash in its operating activities. Accounts receivable turnover gauges the liquidity of a firm's customer receivables and equals net sales divided by average gross receivables.