Commonly Used Financial Ratios

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  • 0:00 What Are Financial Ratios?
  • 1:54 The Current Ratio
  • 4:06 Debt Ratio
  • 5:14 Gross Margin
  • 6:37 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll explore three of the most commonly used financial ratios. We'll also discuss the categories of each, how to calculate each, and how to analyze the data.

What Are Financial Ratios?

Monique is a freshman at Financial State University. She's excited to take a financial analysis course because she has a job offer to be an intern at Money Corporation. This is Monique's first day in class and her professor, Ms. Collins, starts the lecture by asking, 'What is a financial ratio?'

As she looks around the class, no one raises his or her hand. Ms. Collins says, 'A financial ratio is calculated by finding two or more line items from a financial statement, making a mathematical operation, and analyzing the results.'

Financial ratios are important to evaluate the financial health and performance of a company. The users of this information include management, investors, and banks.

Ms. Collins asks another question: 'What are the financial ratio categories?' Monique knew this one from an accounting class in high school, so she raised her hand and said, 'Financial ratios can be classified by liquidity, debt, and profitability'. Ms. Collins smiled at her impressively and said, 'Monique, you're exactly right!'

Ms. Collins goes on to say liquidity means the ability to convert assets into cash. The current ratio is an example of a liquidity ratio. The current ratio shows how quickly we can pay our current liabilities with current assets. The debt ratio is classified in the debt category and shows what percentage of our assets is financed with liabilities. Lastly, a commonly used profitability ratio is the gross profit margin, which explains how much money we have left to pay other expenses after buying our supplies or products to sell.

For the remainder of this lesson, we'll discuss these commonly used ratios in greater detail. You'll also learn how to calculate and analyze them.

The Current Ratio

Ms. Collins starts her explanation of ratio categories by asking the class to raise their hand if they have a savings account at a bank. Then she says, 'OK, put your hand down. Now raise your hand if you own stock. If you want to go out and buy a flat screen TV and have to use a savings account or stock, which group would be able to purchase the flat screen TV the fastest?' The class all said in unison, 'The group with the savings account.'

She replied, 'Exactly, because we can withdraw cash from a savings account faster than we can sell stock, since with stock you must first find a buyer, then sell it, and hope to make a profit.' Similarly, the word liquidity is the ability to turn assets into cash. Assets are items we own that have value. Examples of assets are savings accounts and stock.

Liquidity ratios calculate a business's ability to turn its assets into cash to pay current liabilities. Liabilities are obligations a business owes, such as a loan on a building or truck. One of the most common liquidity ratios is the current ratio. 'Current' in financial terms means to sell, consume, or use within one year.

The current ratio shows the ability to sell current assets to pay current liabilities. The formula is current assets divided by current liabilities. These line items can be found on the balance sheet. If the ratio is equal to or greater than one, then the better the company's ability to pay its current liabilities with its current assets. If the ratio is lower than one, a company may have trouble paying its obligations.

For example, let's say a company has $100,000 in assets and $75,000 in liabilities. The current ratio would be 1.33 ($100,000/$75,000). Since the current ratio is greater than one, the company is capable of paying its current liabilities with its current assets. 'Now, let's look at debt ratio', says Ms. Collins.

Debt Ratio

Next, Ms. Collins explains the debt ratio. She says the debt ratio shows what percentage of assets is financed with liabilities. Remember, liabilities are obligations a company owes, like a loan, and assets are items we own, such as a truck. For example, we might wonder what percentage of the company truck we financed with a loan. The debt ratio gives us this answer by taking total liabilities divided by total assets.

Ms. Collins goes on to say that the lower the ratio, the less percentage of assets is financed with liabilities, meaning you own more of the assets than you owe. For example if a company has $150,000 in total assets and $125,000 in total liabilities, its debt ratio would be 83% ($125,000/$150,000).

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