Define the main categories of ratios used in analysis and provide one example of each (with the equation).
There are many category division systems for financial ratios. One system divides ratios into two categories: solvency and profitability. Other systems have as many as five categories: leverage, liquidity, operating efficiency, profitability, and solvency. Any system of categorization will work, as long as the information can help the business to find out useful ways to maintain itself financially.
The system that is described here has four categories:
1. Liquidity is a measure of the business' ability to pay its short-term debts (which are due in less than than 1 year). This is the first set of ratios that can determine its ability to avoid bankruptcy. A basic example of a ratio in this category is the current ratio, which is the current assets divided by the current liabilities. What is desired is a result that is greater than 1, and as high a number as possible. Illustration: 1000/600 - 1.67
2. Profitability measures the return on an investment of a business' capital assets. It can also be a measure of the financial cushion per dollar of the gross profits of its ...
This is a description of the various financial ratios that businesses use to determine its stability. Examples and illustrations are included.