Ratio analysis is a useful tool for quickly assessing a company’s performance. Ratios are excellent at analyzing several elements of a company.

Ratios can answer questions such as, “How capable are we of paying our debts?” “How effectively are we using our assets?” “How profitable are we?” “How much debt do we have compared to equity?”

There are five main categories of ratio analysis:

1. Liquidity Ratios
2. Turnover Ratios
3. Profitability Ratios
4. Debt Ratios
5. Investment Ratios

Liquidity Ratios

Liquidity ratios attempt to analyze a company’s ability to pay its debt. The more liquid a company is, the more capable it is to pay its debt. With liquidity ratios, it’s not enough to only ask, “Do we have enough assets to pay for our debts?” Instead, we need to ask, “Do we have enough liquid assets to pay for our debts?” Liquid assets are assets that can be quickly converted into cash. If we can convert it into cash, then we can pay our debts.

For instance, suppose we have an upcoming debt payment. We have $0 in cash, but we have $1 million in inventory. Inventory is not a very liquid asset, meaning it takes a long time to convert into cash. We have to finish producing the inventory, sell it, and then wait for accounts receivable to be paid before we have the cash. Therefore, inventory is not considered a liquid asset.

On the other hand, accounts receivable is a much more liquid asset because once we record accounts receivable, it means we’ve already made a sale and now we’re just waiting to collect the cash from it.

Study Tip 😀

Liquidity ratios measure how capable a company is to pay its debts.

Turnover Ratios

The next major area of ratio analysis is turnover ratios. Turnover ratios aim to figure out how often our assets turnover, which refers to how many times in a year we use our assets and replace them.

For instance, with the accounts receivable turnover ratio, we take our net credit sales and divide them by our AR balance.

Imagine if we had $1 million of net credit sales and our average AR balance was $500,000. This would be a poor receivable turnover amount because it means that we converted our AR balance to cash only twice in the year. In other words, it took us an average of six months to collect our cash from AR.

If we had an AR balance of, let’s say, $50,000, our AR turned over 20 times in the year. This would mean we collected our AR on average every 18 days.

A major use of the turnover ratios is for what is called the cash conversion cycle. The cash conversion cycle answers the question, how long does it take us to turn inventory into cash?

The cash conversion cycle examines how long it takes us to obtain the inventory, build the product, sell the product, and then collect the AR from the product.

Study Tip 😀

Turnover ratios focus on how efficient a company is with its assets.

Debt Ratios

Now let’s start discussing our debt ratios. If the liquidity ratios answer the question, “Are we able to pay down our debt?” Then the debt ratios answer the question, “How much debt do we have?” For instance, there’s the debt-to-equity ratio, which asks the question, “For every $1 of equity that you have, how much in debt do you have?”

Profitability Ratios

Now let’s discuss the profitability ratios. These answer the question, “How profitable are we?” For example, we may just focus on a 20% increase in revenue, but we need to consider our profit. Maybe our revenue increased by 20%, but our expenses increased by 25%. Even though we had more sales, our profit was actually lower.

A popular profitability ratio is the profit margin ratio. This answers the question: for every $1 of sales, how many dollars of net income do we have?

Investments Ratios

The last area of ratio analysis is investment ratios. When we hear investment, what does that mean?

First, it means investments that the company itself is making. The company wants to ensure that it’s investing its assets in the right way. Second, these investment ratios are for individual investors who want to buy stock in other companies. These investment ratios assist both companies and individual investors.

Ratio Analysis Tip #1

A common confusion with ratios is determining which number goes on top (i.e., the numerator), and which number goes to the bottom (i.e., the denominator).

To avoid confusion, consider it like this: We’re stating that in the denominator for every of this, we have this many in the numerator. For everyone in the denominator, we have this many in the numerator.

For example, the current ratio is current assets divided by current liabilities. We look at the the denominator, the current liabilities, and say for every $1 of current liabilities we have this many dollars of current assets.

Let’s say that your current assets are $15,000 and your current liabilities are $5,000. Then your current ratio would be $15,000 divided by $5,000 which equals 3, meaning that for every $1 in liabilities, we have $3 of current assets.

Ratio Analysis Tip #2

Anytime you see a ratio like debt-to-equity, the second word goes in the denominator. Here we know that debt goes in the numerator, and equity goes in the denominator. It’s the same thing for a ratio like debt-to-total assets (aka debt ratio). Since total assets is the second term mentioned, it goes into the denominator.

This trick also applies to the “return on ____” ratios. For example, in the return on assets ratio, total assets will be in the denominator. For the return on equity ratio, total equity will be in the denominator.

Ratio Analysis Tip #3

Let’s talk about a tip for the turnover ratios. Here, the name of the turnover ratio is what you put in the denominator. For example, the inventory turnover ratio means the inventory goes into the denominator. Similarly, for the accounts receivable turnover ratio, accounts receivable goes in the denominator.