Decoding Financial Ratios: A Practical Guide

Financial Ratio Analysis

Financial Ratios: What Are They?

• A value based on common financial metrics.
• The result of dividing one financial statement item by another, facilitating interpretation and comparison.

Liquidity Ratios

Ability to meet short-term obligations.

Current Ratio = Current Assets / Current Liabilities

Measure: Ability to pay short-term debts.

Interpretation: The higher the ratio, the better the liquidity position, although it may represent some short-term debt or excess assets.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Measure: Ability to pay quickly in the short term.

Interpretation: The higher the ratio, the better the liquidity position, although it may represent some short-term borrowing or excess assets.

Activity Ratios

Speed with which accounts are converted into sales or cash.

Average Collection Period = Accounts Receivable / Daily Sales

Measure: Average period a company takes to collect its accounts receivable.

Interpretation: The lower the ratio, the more efficient the administration of accounts receivable.

Inventory Turnover = Cost of Sales / Inventory

Measure: Times that the inventory is sold or renewed in the period.

Interpretation: A major indicator of efficiency in inventory management. It may represent a low level of inventories that can cause lost sales.

Debt Ratios

Extent to which the firm finances with debt.

Debt Ratio = Total Liabilities / Total Assets

Measure: Proportion of total assets financed with funds from creditors.

Interpretation: Indicates the extent to which a company uses third-party resources to generate profits.

Profitability Ratios

Level of profitability generated by the company.

Gross Profit Margin = Gross Profit / Sales

Measure: Percentage of sales left to the company after paying the cost of goods sold.

Interpretation: A higher ratio indicates a lower relative cost of goods sold and a better ability to generate income before operating expenses.

Return on Equity (ROE) = Net Income / Equity

Measure: Performance obtained by investment of the owners.

Interpretation: The higher the ratio, the better the performance obtained by the owners for the resources invested in the company.