Business owners, managers and financiers use ratio analysis to understand how effectively a business is operating. Ratios are benchmarks calculated by relating two or more pieces of financial data about the business. That data is usually taken from the income statement and/or the balance sheet.
Ratio analyses are used to make both internal comparisons (within a business) and external comparisons (against other companies in the same industry). They may use current results or historical results to identify trends over time.
The three most common types of ratio analysis are those used to measure liquidity (the ability to convert short-term assets to cash), debt (the capacity to service current debt loads and raise new debt) and profitability (how productively the company’s assets are used to create value).
More about ratio analysis
The following are common ratios used to assess the performance of a business:
Liquidity
- Acid-test ratio
- Current ratio
- Payables turnover
- Average collection period
- Inventory turnover
- Working capital
These ratios are measures of short-term liquidity
Debt
These ratios are also measures debt capacity
Profitability
- Return on common equity ratio
- Net profit margin ratio
- Gross profit margin ratio
- Return on shareholders’ equity
- Return on total assets.
These ratios are also measures of productivity
