Key Financial Ratios: What the Numbers Reveal

For business owners and managers, monitoring key financial ratios reveals the organization's strengths and weaknesses and, therefore, help guide management's decision-making and forecasting. In addition, bankers, creditors, investors, and government agencies often use them to evaluate a firm's health for lending purposes.

Financial ratios are divided into four classifications. Operating ratios assess management's performance; leverage ratios measure the company's financial risk; coverage ratios calculate the firm's ability to meet fixed obligations; while liquidity ratios estimate the organization's ability to meet short-term obligations.

Of the four categories, the most common financial ratios are those indicating a firm's ability to generate cash and pay its bills, or the liquidity ratios. Frequently requested liquidity ratios include the current ratio, quick ratio, accounts receivable turnover and inventory turnover ratios. The total asset turnover ratio, also an operating ratio, is used for evaluating liquidity.

The Current Ratio compares current assets to current liabilities and measures a company's ability to meet current financial obligations. A higher current ratio, indicating lower risk and suggesting adequate working capital, is preferred. If current assets include excess receivables or obsolete inventory, the ratio generated could be misleading by inflating the firm's short-term financial strength.

The Quick Ratio (aka acid test or quick assets ratio) gauges short-term liquidity by comparing the most liquid assets, cash and accounts receivables, against current liabilities to meet short-term obligations. A higher quick ratio conveys less risk and a healthier organization.

The Accounts Receivables Turnover Ratio compares net sales against accounts receivables to determine how often receivables are collected annually. A high ratio indicates excellent liquidity and an efficient use of assets to extend credit and collect debt. A low ratio suggests that credit policies should be revised since outstanding credit increases the firm's expenses.

The Inventory Turnover Ratio analyzes cost of goods sold to inventory and indicates how often the inventory is sold and replaced over a given period. A low turnover implies poor sales and excess inventory. High inventory levels adversely affect Return on Investment (ROI) and pose financial trouble when prices drop or the product becomes obsolete. A high turnover may indicate either strong sales or ineffective buying. Too high a ratio may reflect the loss of sales due to stock outs, back orders, and the firm's inability to obtain adequate supplies of goods from its suppliers. Inventory turnover ratios are best compared against industry averages.

The Total Asset Turnover Ratio compares assets to revenue and shows how efficiently assets are used to generate sales. Hence, a certain level of assets is needed to generate a certain level of sales. This ratio should remain relatively constant and is generally useful for growth companies to ensure revenue grows proportionately to sales.

Many financial ratios exist, with the importance of each varying by the industry and individual business. Liquidity ratios, however, are the most commonly used ratios to analyze a firm's financial stability and ability to meet short-term debt obligations. Many sources, such as banks, rely on key financial ratios to track performance over time, assess the company's performance relative to competitors, and predict future success.