Financial ratios are calculations used to measure and analyse various aspects of a company’s financial performance. These ratios are important because they provide an objective and structured way of understanding a company’s financial health and performance.
Types of financial ratios
There are many types of financial ratios that can be used, each with their own specific purpose. Some of the most common financial ratios are:
- Liquidity ratios: these ratios measure a company’s ability to meet its short-term liabilities, in other words the company’s liquidity. This includes ratios such as current ratio and quick ratio.
- Profitability ratios: these ratios measure how profitable a company is. Some examples are gross margin, net margin and return on investment (ROI).
- Solvency ratios: these ratios measure a company’s ability to meet its long-term liabilities, in other words its solvency. This includes ratios such as debt-to-equity ratio and interest coverage ratio.
Why are financial ratios important?
Financial ratios are significant because they allow investors, creditors, analysts and other stakeholders to compare and evaluate a company’s financial performance. By using ratios, they can better understand a company’s financial health and performance and make decisions based on objective and structured information. Thus, this can also influence getting a loan or other alternative forms of financing.
It is essential to note that financial ratios only tell part of the story and should be used in conjunction with other information, such as a company’s operational performance and strategic plans. Nevertheless, financial ratios provide an important tool to assess how a company is performing and whether it is likely to be successful in the long term.