Financial ratios show relationships between items and are widely used in analyzing financial statements. Ratios themselves do not explain the causes of relationships; You need to interpret them to figure out what’s going on in your business.
There are a large number of financial ratios that can be calculated, so select the most significant ratios in your industry to study. Each business has its own critical ratios that should be watched carefully. Financial ratios can be grouped roughly into four families according to the type of insights the ratio offers:
1. Profitability: These ratios show the relationship between earnings and sales or assets. Common profitability ratios include return on sales, return on assets, and return on equity.
2. Liquidity: These ratios indicate an organization’s ability to pay current bills. Common liquidity ratios include current ratio and the acid test ratio.
3. Asset use: Asset use ratios show the volume of business being generated by the investment in assets. Common asset use ratios are receivables collection period and inventory turnover.
4. Capitalization: These financial ratios show how an enterprise finances its business. Leverage on capital, leverage on equity, and long-term debt to capital are common capitalization ratios.
When analyzing a specific organization, you should look at its operation and key financial ratios over time and in comparison with industry trends which are widely available. The Risk Management Association (www.rmahq.org) publishes the Annual Statement Studies: Financial Ratio Benchmarks, which provides ratio data by performance quartiles for a wide range of industries.
William W. Sihler (Charlottesville, VA) is Trzcinski Professor of Business Administration at the University of Virginia’s Darden School. Richard D. Crawford (Charlottesville, VA) has extensive experience in banking, commercial finance, and private equity, and is currently a Visiting Lecturer at Darden. Henry A. Davis (Charlottesville, VA) is a consultant specializing in corporate finance and banking,. He is managing editor of The Journal of Project Finance and Strategic Investor Relations.