Question 1

What are financial ratios?

Accepted Answer

Financial ratios definition: Purpose: Assess financial health, compare to benchmarks, track trends over time, support decisions, communicate to stakeholders. Categories: Liquidity ratios - ability to pay short-term obligations, profitability ratios - earning performance, efficiency ratios - asset utilization, leverage ratios - debt levels and risk. Calculation: Ratio = one financial measure divided by another, use balance sheet and income statement data, consistent calculation method, compare to same period. Uses: Internal management, investor analysis, lender evaluation, benchmark comparison, trend monitoring. Interpretation: Ratio alone less meaningful, compare to industry, track trends, consider context, use multiple ratios together. Financial ratios = health indicators. Calculate consistently. Compare to benchmarks. Track trends. Use for decisions. Context matters.

Question 2

What are key liquidity ratios?

Accepted Answer

Liquidity ratios: Current Ratio: Formula = Current Assets / Current Liabilities, measures short-term solvency, target > 1.5 (varies by industry), too low = liquidity risk, too high = inefficient asset use. Quick Ratio (Acid Test): Formula = (Cash + Marketable Securities + AR) / Current Liabilities, excludes inventory, stricter measure, target > 1.0, inventory may be hard to liquidate quickly. Cash Ratio: Formula = Cash / Current Liabilities, most conservative, only cash considered, target > 0.5, rarely used alone. Interpretation: Higher = better liquidity, but not always optimal, industry benchmarks essential, track trends, sudden changes investigate. Liquidity = ability to pay now. Current ratio most common. Quick ratio stricter. Cash ratio conservative. Balance liquidity with efficiency.

Question 3

What are key profitability ratios?

Accepted Answer

Profitability ratios: Gross Margin: Formula = (Revenue - COGS) / Revenue, measures production/service efficiency, varies widely by industry, higher = better pricing or efficiency, track for trends. Net Margin: Formula = Net Income / Revenue, measures overall profitability, includes all expenses, target > 5-10% typical, varies by industry. Return on Assets (ROA): Formula = Net Income / Total Assets, measures asset utilization efficiency, how well assets generate profit, target > 5% typical. Return on Equity (ROE): Formula = Net Income / Shareholder Equity, measures return to owners, critical for investors, target > 10% typical, higher = better. Profitability = earning ability. Margins show efficiency. Returns show effectiveness. Industry benchmarks essential. Track trends, act on declines.

Question 4

What are key efficiency ratios?

Accepted Answer

Efficiency ratios (activity ratios): Inventory Turnover: Formula = COGS / Average Inventory, measures inventory management, higher = faster sales, too high = stockout risk, industry benchmarks apply. Accounts Receivable Turnover: Formula = Revenue / Average AR, measures collection efficiency, higher = faster collection, relates to DSO calculation. Accounts Payable Turnover: Formula = Purchases / Average AP, measures payment timing, relates to DPO calculation, balance with vendor relationships. Asset Turnover: Formula = Revenue / Total Assets, measures overall asset efficiency, higher = better utilization, varies by industry (capital-intensive lower). Efficiency = asset utilization. Higher ratios generally better. But balance with risk. Track trends. Industry benchmarks vary. Optimize operations based on ratios.

Question 5

What are key leverage ratios?

Accepted Answer

Leverage ratios (debt ratios): Debt Ratio: Formula = Total Debt / Total Assets, measures debt financing proportion, target < 0.5 typical, higher = more debt reliance, risk indicator. Debt to Equity Ratio: Formula = Total Debt / Shareholder Equity, measures debt vs ownership, target < 1.0 typical, higher = more leverage, riskier for creditors. Interest Coverage Ratio: Formula = EBIT / Interest Expense, measures ability to pay interest, target > 3 typical, lower = interest payment risk, critical for lenders. Interpretation: Higher leverage = higher risk, but also potential higher returns, industry norms vary, consider business cycle, balance debt with equity. Leverage = debt risk. Lower ratios safer. But some debt normal. Match to industry. Monitor interest coverage. Debt strategy should be intentional.

Financial Ratio Guide

Liquidity Ratios

Profitability Ratios

Efficiency Ratios

Leverage Ratios

Ratio Analysis Checklist