Introduction to Ratios: Study with Video Lessons, Practice Problems & Examples

Understanding financial ratios is crucial for analyzing a company's performance. Ratios fall into five categories: liquidity ratios assess cash availability; financial leverage ratios evaluate long-term debt management; efficiency ratios measure asset utilization; profitability ratios indicate earnings; and market value ratios reflect stock price dynamics. Ratios are calculated by dividing one number by another, providing insights into financial health. Analyzing these ratios involves comparing them against industry benchmarks, historical data, and thresholds to identify trends and potential issues, enhancing decision-making for investors and management.

Introduction to Ratios

A significant part of being able to analyze financial information is to use ratios. Let's go ahead and introduce you to the concept of ratios and see how it relates to accounting. So like I said, it's going to be a big part of financial analysis here, right? We're going to see that companies and investors alike are going to use ratios all the time to make informed decisions. So in accounting, we are going to be using a bunch of different types of ratios, and they usually fall into one of these 5 categories, okay? The first kind are liquidity ratios or solvency ratios. Remember that liquidity is how much cash you have. And solvency is being able to pay your debts. So, do you have enough cash to pay your debts, your current assets, and your current liabilities? They are going to deal a lot with that, okay? So being able to pay your short-term obligations, okay? And then we've got financial leverage. This deals more with long-term obligations, okay? This has to do with long-term debt and being able to manage your assets and manage your business to be able to pay off those debts when they come due. So this has to do with long-term obligations. And then we are going to have efficiency ratios. These are our turnover ratios. How effectively are we using different assets? Inventory, how effectively are we using all of our assets? Our fixed assets? How effectively are we using our accounts payable? Our ability to pay our suppliers over time, okay? So this is how efficiently companies use their assets and sometimes their liabilities we might talk about as well. Profitability ratios, guess what that deals with? Well, it measures how profitable the company is, right? How much money are they making? We use profitability ratios in that sense. And then finally, we've got market value ratios. These deal more with the investor themselves. Here, we're going to be using the actual market price of the stock. So when we think about Apple stock, well, there's some book value, some value on the balance sheet for the stock, but that's going to be significantly different than the open market value of Apple stock, right? Because the book value, remember, that's the historical cost. But Apple probably is a lot bigger than it was when it first started, right? So the market price is going to be a lot higher there. It can be different than the book value. So those market value ratios, they deal with what kind of investment should I make at this point with the current market price. Alright? So in general, when we deal with ratios, we're always just going to be dividing one number by another number, right? And that number in the numerator or the denominator, it could be a group of numbers. It could be an addition or a subtraction. We might have to do a calculation in the numerator, a calculation in the denominator to get to our ratio, okay? But in general, we're just going to be dividing one number by another number. So ratio is just a divided by b. Just like I've described here. And the best way to think about a ratio, when you do that division, right? What we're going to be left with is some sort of decimal. It'll give you a decimal, it could be like something over 11.34 or like something below 1 like 0.04, 0.08. Whatever it is. Let's say you get in this example, 1.54 as I have in the example below. Well, remember that every number is just divided by 1, right? Every number can just be divided by 1 and it's the same number. So what I'm saying here is that for every unit of b, right? For every unit of the denominator, for every one unit of the denominator, well, that means there's 1.54 units of the numerator. So a lot of times when you make a ratio, it's not just simply calculating the ratio. You have to get a company, you're going to get their financial statements and you have to calculate all these ratios for that company and do a little bit of analysis. So we're going to have videos for each different type of ratio that you're going to come across and how to analyze those ratios and how to deal with them and practice problems on how to calculate them as well. Cool? So this is just a general introduction to ratios here and then we're going to dive into specific ratios, as you need them in your class. Cool? So remember that when you analyze a ratio, it means that for each unit of B, for each unit of the denominator, there's going to be 1.54 units of the numerator, or whatever the right, whatever the ratio gives you that is how we interpret it. Okay? So let's go ahead and think about how we're going to analyze these ratios. So like I said, we have to analyze these ratios after we calculate them. But how do we analyze them? Well, there are going to be some ratios that have thresholds, right? There's going to be some ratio that needs to be above a certain number or else it's a red flag. It's like, hey, something's wrong here if you don't keep a certain balance in this ratio. So there could be a threshold to help us analyze a ratio. Next, we can use what's called benchmarking. We can benchmark against other companies, right? We're going to calculate a ratio for our company and then we'll say okay, this is the ratio for our company. How are our competitors doing? Or how's the industry average in our industry? What is our ratio compared to those numbers, right? So we will be able to make better decisions based on how we compare to other companies. And finally, we can compare ratios to prior periods, right? We can compare the ratio this year that we calculated to the ratio last year for the same company, right? Just to notice if there are any trends, any changes in the ratio, that could help give us some information as well. So let's go ahead and do a completely accounting unrelated ratio right here to get us going and thinking about ratios. So let's go ahead and

Here’s what students ask on this topic:

What are liquidity ratios and why are they important in financial analysis?

Liquidity ratios measure a company's ability to meet its short-term obligations using its most liquid assets. Key liquidity ratios include the current ratio and the quick ratio. The current ratio is calculated as:

$\frac{\mathrm{Current} \mathrm{Assets}}{\mathrm{Current} \mathrm{Liabilities}}$

Liquidity ratios are crucial because they provide insights into a company's financial health and its ability to pay off short-term debts, which is essential for maintaining operations and avoiding insolvency.

How do financial leverage ratios help in assessing a company's long-term financial stability?

Financial leverage ratios evaluate a company's ability to manage its long-term debt and financial obligations. Key ratios include the debt-to-equity ratio and the interest coverage ratio. The debt-to-equity ratio is calculated as:

$\frac{\mathrm{Total} \mathrm{Debt}}{\mathrm{Shareholders\text{'}} \mathrm{Equity}}$

These ratios are important because they indicate the level of financial risk a company is taking on and its ability to meet long-term obligations, which is vital for long-term financial stability and growth.

What are efficiency ratios and how do they impact a company's performance analysis?

Efficiency ratios, also known as turnover ratios, measure how effectively a company uses its assets and liabilities. Key ratios include inventory turnover and accounts receivable turnover. The inventory turnover ratio is calculated as:

$\frac{\mathrm{Cost} \mathrm{of} \mathrm{Goods} \mathrm{Sold}}{\mathrm{Average} \mathrm{Inventory}}$

Efficiency ratios are crucial because they provide insights into how well a company is managing its resources, which directly impacts profitability and operational performance.

How do profitability ratios help in evaluating a company's financial performance?

Profitability ratios measure a company's ability to generate earnings relative to its revenue, assets, equity, and other financial metrics. Key ratios include the net profit margin and return on equity (ROE). The net profit margin is calculated as:

$\frac{\mathrm{Net} \mathrm{Income}}{\mathrm{Revenue}}$

These ratios are important because they provide insights into a company's efficiency in generating profits, which is essential for assessing overall financial health and performance.

What are market value ratios and how do they influence investment decisions?

Market value ratios assess a company's stock price relative to its earnings, book value, and other financial metrics. Key ratios include the price-to-earnings (P/E) ratio and the market-to-book ratio. The P/E ratio is calculated as:

$\frac{\mathrm{Market} \mathrm{Price} \mathrm{per} \mathrm{Share}}{\mathrm{Earnings} \mathrm{per} \mathrm{Share}}$

These ratios are crucial for investors as they provide insights into whether a stock is overvalued or undervalued, helping in making informed investment decisions.