A ratio is a comparison of two figures. They are culled from the financial statements of a company. These help in assessing the financial health of a company. It could be a ratio between an item from a balance sheet versus another item on the balance sheet. Or it could be a ratio between one figure of the balance sheet with a figure from Profit and Loss account or it could be comparison of one year's figure with a figure from the previous year.For example Return on Equity = Net profit (A Profit and a Loss figure) divided by Net Worth (a balance sheet figure) in percentage terms.
What are the various kinds of financial ratios?
There are many financial ratios. Some of the better known include:
Liquidity Ratios: Liquidity ratio measures the ability of a firm to meet its current obligations. Liquidity ratios by establishing a relationship between cash and other current assets to current obligations give measure of liquidity.e.g. Current ratio = Current Assets/Current liabilities.A high CR ratio (>2.5) indicates that a company can meets its short term liabilities.
Leverage Ratios: Leverage ratio indicates the proportion of debt and equity in financing the firm's assets. They indicate the funds provided by owners and lenders.e.g -----Debt-equity ratio (D-E ratio) total long term debt/net worth.A high D-E ratio indicates that the company's credit profile is bad.
Activity Ratios: Activity ratios are employed to evaluate the efficiency with which firms manage and run their assets. They are also called turnover ratios.e.g-- Sales Turnover ratio = sales/total assets .A Sales Turnover ratio indicates how much business a company generates for every additional rupee invested.
Profitability Ratios: These ratios indicate the level of profitability of the business with relation to the inputs or capital employed. Some better-known profit ratios include operating profit margin (OPM). Operating profit margin is a measure of the company's efficiency, either in isolation or in comparison to its peers.