As a CFO, I spend most of my time talking about financial ratios. But what exactly are they? Let me simplify it for you.
Financial ratios are simply a way to measure a company's financial performance. They are calculated using the financial statements of the company, including the income statement, balance sheet, and cash flow statement. These ratios help investors, analysts, and even management to understand how the company is performing financially and where improvements need to be made.
There are several types of financial ratios that can be calculated, but I’m only going to cover the most important ones:
Liquidity ratios measure a company's ability to meet its short-term obligations. They indicate whether the company has enough current assets (like cash) to cover its current liabilities (like unpaid bills). The two most common liquidity ratios are the current ratio and the quick ratio.
Profitability ratios measure how efficiently a company is generating profits. They help investors and analysts determine whether the company is making money and how well it’s being managed. Profitability ratios include gross profit margin, net profit margin, and return on equity (ROE).
Debt ratios measure how much debt a company has compared to its assets or equity. These ratios are important because they indicate how much risk the company is taking on by borrowing money. The most common debt ratios include debt-to-equity ratio and debt-to-asset ratio.
Efficiency ratios measure how well a company is using its assets to generate revenue. They indicate whether the company is using its resources (like inventory and accounts receivable) efficiently. Efficiency ratios include inventory turnover ratio, accounts receivable turnover ratio, and total asset turnover ratio.
Now that you know what financial ratios are and the types of ratios that exist, the question is: why should you care about them?
The answer is simple: financial ratios give you insight into a company's financial performance and help you make informed investment decisions. By studying a company's financial ratios, you can see whether the company is profitable, how it’s managing its debt, and whether it’s using its assets efficiently. When you are interested in investing in a company, you need to analyze its financial ratios and compare them to other industry benchmarks, over time, or across companies.
Financial ratios are a critical tool for investors, analysts, and management to evaluate a company's financial health. They offer an in-depth understanding of how a company is performing and where improvements can be made. The next time you are considering investing in a company or looking into your own company's financial performance, make sure you understand and know how to use financial ratios.