Summary

Ratios used in financial analysis can help investors and other analysts identify trends over time, compare companies to one another, and make informed decisions about a company. There are, however, limitations to analysis, so it should be used wisely and in conjunction with other contextual information available.

Efficiency ratios measure how well management uses the assets of the organization to earn a profit. Common efficiency ratios include accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory.

Liquidity ratios help analysts measure how well an organization can meet its short-term obligations (liabilities) as they come due. Common ratios to measure liquidity include the current ratio, the quick ratio, and the cash ratio. Each of these three ratios includes more (cash ratio) or less liquid (current ratio) current assets in its measure of liquidity.

Solvency ratios measure how well an organization can meet its long-term obligations (liabilities) as they come due, or in more general terms, its ability to stay in business. Common solvency ratios include the debt-to-assets ratio and the debt-to-equity ratio.

Market value ratios help analysts assess the value of publicly traded firms in the market. The most commonly used market value ratios include earnings per share (EPS), the price/earnings ratio, and book value per share.

Profitability ratios help measure how effectively the organization earns a profit. Common profitability ratios include profit margin, return on total assets, and return on equity. The DuPont method breaks down return on equity into three smaller components for a more thorough assessment of performance: profit margin, total asset turnover, and an equity multiplier.