It is hard to get a good sense of the financial performance of a firm based on a quick glance of the firm’s balance sheet, income statement, or cash flow statement. As a result, we often calculate financial ratios that help us communicate information about the financial performance of the firm. By using financial ratios, we get a better understanding of what values on the financial statements are actually telling us, if they are good or bad, and where they may need to be improved.

__1. Solvency Ratios__

Solvency ratios look at whether or not the firm can meet its current obligations as they become due. The most widely used measure of liquidity are the *current ratio *and the *quick ratio.*

__2. Activity Ratios__

Activity ratios look at how effectively the firm’s assets are being managed. Firms invest in a number of short-term and long-term assets, and these investments depend on a number of different factors. It may be important to know how firm manages its investments in accounts receivables (so that it can set appropriate credit policy) and inventory (so that it can set appropriate inventory management policy). The most common activity ratios are *total asset turnover ratio*, *receivables turnover ratio*, *and inventory turnover ratio*.

__3. Profitability Ratios__

The size of the firm is very important when analyzing the firm’s profitability. Imagine two companies that both make $100,000/year. One would cost you $100,000 to buy, one would cost you $1,000,000 to buy – which would you prefer? The answer is obviously the first. Typically we calculate a firm’s *profit margin*, then look at ratios such as *return on assets *(which gives us a sense of the total value of the firm), and *return on equity* (which gives us a sense of the return to shareholders). We can also calculate the *payout ratio *(how much of the firms income it pays out in dividends) and the *retention ratio *(how much of the firm’s net income it keeps as retained earnings to reinvest each year).

__5. Market Value Ratios__

Until now, we’ve looked at ratios that are calculated using accounting numbers. However, accounting values are not adjusted for things such as risk and interest rates. As a result, the market value of the firm may differ substantially from its book value. Market value ratios are important because the market value should reflect the true value of the firm. Common market value ratios include the *price-to-earnings (P/E) ratio, dividend yield, *and the *market-to-book (M/B) value *or *Tobin’s Q ratio*.

# Financial Ratios

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## BrainMass Categories within Financial Ratios

### Current Ratio

The current ratio provides information about the solvency of a firm. It is equal to the current assets divided by the firms current liabilities.

### Quick Ratio

The quick ratio provides information about the solvency of a firm. It is equal to the quick assets divided by the current liabilities.

### Asset Turnover

Asset turnover is an activity ratio that provides information about how effectively management is using the firm's assets to generate sales. Asset turnover is equal to sales divided by average total assets.

### Receivables Turnover

Receivables turnover is an activity ratio that provides information about the effectiveness of the firm's credit policy. It is equal to sales divided by average accounts receivable.

### Inventory Turnover

Inventory turnover is an activity ratio that provides information about the life span of the firm's inventory. It is equal to the cost of goods sold divided by average inventory.

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### Debt Ratio

The debt ratio, debt-to-equity ratio and equity multiplier provide information about the capital structure of the firm.

### Interest Coverage

The interest coverage ratio provides us information about how well a firm is able to generate earnings to cover its interest expense. It is equal to EBIT divided by interest expense.

### Profit Margin

A firm's profit margin provides information about how much profit the firm will keep for every dollar of sales it makes.

### Return on Assets (ROA)

The return on assets shows us how effectively management is using the firm's assets to generate earnings. It is a function of asset turnover and profit margin.

### Return on Equity (ROE)

The return on equity shows us how effectively management is using the firm's assets to generate earnings for shareholders, adjusting for leverage. It is a function of asset turnover, profit margin and the equity multiplier.

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### Payout, Retention and Growth Ratios

The payout ratio is the proportion of net income the firm pays out as dividends. Conversely, the retention ratio is the proportion of net income the firm keeps to reinvest. The growth rate is a function of the retention ratio and the expected return on retained earnings.

### Price-to-Earnings (P/E) Ratio

The P/E ratio provides information about what price the stock is trading at in proportion to its earnings. It is equal to the price per share divided by earnings per share.

### Dividend Yield

The dividend yield provides information about how much dividends a firm pays in proportion to the price its stock is trading at. It is equal to the annual dividend per share divided by the market price per share.

### Market-to-Book Value and Tobin's Q

The market-to-book value and Tobin's Q look at how the value of the firm relates to its historical cost of equity and the replacement value of its assets.

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