Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:
* Liquidity ratios
* Asset turnover ratios
* Financial leverage ratios
* Profitability ratios
* Dividend policy ratios
Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its shortterm financial obligations. They are of particular interest to those extending shortterm credit to the firm. Two frequentlyused liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.
The current ratio is the ratio of current assets to current liabilities:
= 

One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:
Quick Ratio  = 

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:
Cash Ratio  = 

Asset Turnover Ratios
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows:
Receivables Turnover  = 

Average Collection Period  = 

Average Collection Period  = 

Inventory Turnover  = 

Inventory Period  = 

Inventory Period  = 

Financial Leverage Ratios
Financial leverage ratios provide an indication of the longterm solvency of the firm. Unlike liquidity ratios that are concerned with shortterm assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.The debt ratio is defined as total debt divided by total assets:
Debt Ratio  = 

DebttoEquity Ratio  = 

The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:
Interest Coverage  = 

Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at generating profits.The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:
Gross Profit Margin  = 

Return on Assets  = 

Return on Equity  = 

Dividend Policy Ratios
Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.The dividend yield is defined as follows:
Dividend Yield  = 

Payout Ratio  = 

Use and Limitations of Financial Ratios
Attention should be given to the following issues when using financial ratios: A reference point is needed. To to be meaningful, most ratios must be compared to historical values of the same firm, the firm's forecasts, or ratios of similar firms.
 Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm's situation.
 Yearend values may not be representative. Certain account balances that are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available.
 Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values.
Source: www.netmba.com
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