Financial ratios are useful indicators of a firm’s performance and financial situation. Most a measure of profitability is the can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm’s financials to those of other firms.
In some cases, ratio analysis can predict future bankruptcy. Financial ratios can be classified according to the information they provide. Liquidity Ratios Liquidity ratios provide information about a firm’s ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm’s assets are working to grow the business. Typical values for the current ratio vary by firm and industry.
For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The current assets used in the quick ratio are cash, accounts receivable, and notes receivable.
These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test. Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is an indication of the firm’s ability to pay off its current liabilities if for some reason immediate payment were demanded. Asset Turnover Ratios Asset turnover ratios indicate of how efficiently the firm utilizes its assets.
They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover. The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. Another major asset turnover ratio is inventory turnover. Other asset turnover ratios include fixed asset turnover and total asset turnover.