Introduction to Financial Ratios

A logical follow-up after working your way through Balance Sheets and P&L is to look into ways to gain additional insights in it. The most logical and easy way is to compare different periods, such as current year vs last year or current month vs last month. If there is a budget or an industry benchmark, you should compare it with that as well.
There is however another way to quickly understand what you are looking at, and this is called ratio analysis. With a bit of luck this can easily be done in an Excel sheet, and if constructed well it will end up to be a set of KPIs that highlight potential problems ahead. Let’s take a deeper look at what ratios analysis entails.

They typically fall into four different categories, I like to think of them as ‘ratio families’:
• Liquidity
• Profitability
• Solvency
• Cash-flow
Let’s start looking into Liquidity:
Potential subcategories will be:
• Current ratio
• Acid test
• Net working capital
• Need for net working capital
• Days of Sales Outstanding
• Days of Supplier Credit
• Inventory Turnover

The second set of ratios, Profitability, is much more commonly known. There are:
• Operational profitability
• Return on Equity
• Return on Assets

Finally Solvency ratios will tell you everything on the long term financing:
• Debt-to-equity ratio
• Debt coverage
Financial leverage

 

Finally, Cash flow is a crucial, but often misunderstood, concept that needs additional clarification.

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About curiousmanager

In life there are generalists and specialists. Although your job pushes you down towards a certain specialization, I feel it's important to keep your eyes and mind open for new stimuli. And I want to share my journey through arts, literature and sciences with other knowledge workers and managers. You don't have time to read. Let me do that for you and present only the best of the best in my blog!
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One Response to Introduction to Financial Ratios

  1. Metrina says:

    Hi curiousmanager,

    thanks again for your helpful and amusing introduction. “Ratio families” is definitely a proper name for these! However, would you like to elaborate on each remember in this family? It would be awesome if you could explain, for example, need for net WC., among others.

    This thing is that I learned most of them in my finance class and know the formula, but I don’t know how and when to use them in real life. In what context should they be used and how to interpret the results? How will those results help to made decisions in running companies?

    I would extremely appreciate if you could solve my puzzle, which has been following me since my first corporate finance course. Thanks in advance!

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