Financial Ratios

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Investors and other external users of financial information will often need to measure the performance and financial health of an organization. This is done in order to evaluate the success of the business, determine any weaknesses of the business, compare current and past performance, and compare current performance with industry standards. Financially stable organizations are desirable, because a financially stable business is one that successfully ensures its ability to generate income for investors and retain or increase value.

There are many different methods that can be used alone or together to help investors assess the financial stability of an organization. One of the most common methods is financial ratio analysis. The basic ratios include five categories: profitability ratios, liquidity ratios, debt ratios, and asset activity ratios.

Profitability Ratios

Profitability ratios measure the profitability of the organization. They include the gross profit margin, operating profit margin, net profit margin, the return on assets (ROA) ratio, and the return on equity (ROE) ratio.

The gross profit margin is calculated by taking the amount of gross profit and dividing it by sales. This ratio is used to determine the amount of profit remaining from each sales dollar after subtracting the cost of goods sold. Example: a gross profit margin of 0.05 indicates that 5% of sales revenue is left to use for purposes other than the cost of goods sold.

The operating profit margin is calculated by taking earnings before income and taxes and dividing it by sales. This ratio is used to determine how effective the company is at keeping production costs low. Example: an operating profit margin of 0.17 indicates that after subtracti...

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...ventory that does not sell well. Example: an inventory turnover ratio of 66.67 indicates that inventory was sold 66.67 times during the year.

The total asset turnover ratio is calculated by taking total sales and dividing it by total assets. This ratio is used to determine how effective the company is at using all assets to generate sales. Example: a total asset turnover ratio of 0.68 indicates that the dollar amount of sales was 68% of all assets.

Conclusion

Financial ratio analysis can be an invaluable resource to investors and external users who must determine the financial stability of an organization. This is important, because financial stability represents the soundness, dependability, and efficiency of the business. Understanding how to calculate and interpret financial ratios is an important step in analyzing the financial health of an organization.

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