Financial statements (balance sheets and profit & loss account) show how much profit a business has made and how it is using the money invested. However by looking at financial statements alone it is difficult to fully assess how a business is growing and whether it is financially secure. Financial Ratios will help you to work out how well a business is doing based on its size, history, and the money invested in it.
Ratios are divided into five categories
- Profitability Ratios
- Liquidity Ratios
- Gearing Ratios
- Activity Ratios
- Shareholder Ratios
As the name suggests these ratios look at profit. Profitability ratios examine the relationship between gross profit, net profit and the money invested in the business.
In the financial world liquidity means cash, therefore liquidity ratios focus on current assets as they can easily be turned into cash. They also cover current liabilities as these may reduce the amount of liquidity that the business has. Current liabilities are short term debt that needs to be paid off in less than a year.
Gearing ratios focus on the long term debt that the business has. Long term debt is debt that the business as more than a year to pay back. Gearing ratios are said to examine a business’ long term financial standing.
A business’ key activity is to sell stock and receive the money that it is owed from the sale. As a result activity ratios concentrate on how much money the stock generates, how quickly stock is sold and how long it takes to receive money from debtors.
Shareholder ratios reveal the relationship between share prices, the number of ordinary shares, the business’ profit after tax (retained profit/company earnings), and any dividend that the company has paid out.