4 main groupings of ratios. In your opinion, which of the ratios are most important? Also, why is it important to perform a trend analysis of the ratios over a period of years?

1. Liquidity Ratios

Current ratio = Current assets/current liabilities

Quick ratio = (Current assets-Inventories)/current liabilities

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

In general, the higher the current and quick ratios, the greater the liquidity (also known as solvency) of the firm.

Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason immediate payment were demanded.

1. Asset Management Ratios

Inventory turnover ratio = sales/inventories

DSO = Receivables / average sales per day

Fixed asset turnover ratio = sales/net fixed assets

Total assets turnover ratio = sales/total assets

Asset management ratios, specifically the inventory turnover ratio, the fixed asset turnover ratio, and the total asset turnover ratio provide insight into how efficiently (or effectively) the firm's managers are utilizing the company's asset base. Generally speaking, high turnover ratios mean the company is being run more efficiently.

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.

The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:

Total asset turnover. The ratio of the value of a company's sales or revenues generated relative to the value of its assets. The Asset Turnover ratio can often be used as an indicator of the efficiency with which a company is deploying its assets in generating revenue. Generally speaking, the higher the asset turnover ratio, the better the company is performing, since higher ratios imply that the company is generating more revenue per dollar of assets. Yet, this ratio can vary widely from one industry to the next.

1. Financial Leverage Ratios/Debt Management Ratios

Debt Ratio = Total Debt/Total Assets

Interest Coverage = EBIT/ Interest Charges

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. The debt ratio is defined as total debt divided by total assets:

The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:

1. Profitability Ratios

Profit margin on sales = Net income/sales

Earning power ratio = EBIT/total assets

Return on Assets ratio = Net income/total assets

ROE = Net income/common equity

1. Market Value Ratios

PE = Price per share/earnings

Cash flow = Price per share/cash flow per share

Book value = Common equity/shares outstanding

Gross Profit Margin = [Sales - Cost of Goods Sold] / Sales

Return on Assets = Net Income /Total Assets

Return on Equity = Net Income / Shareholder Equity

Profitability ratios offer several different measures of the success of the firm at generating profits.

In general, higher P/E ratios are seen as a positive sign

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs.

Return on assets is a measure of how effectively the firm's assets are being used to generate profits.

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows:

1. Dividend Policy Ratios

The dividend yield is defined as follows: Dividend Yield = Dividends Per Share/ Share Price

Payout Ratio = Dividends Per Share/Earnings Per Share

Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.

A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend payout ratio is helpful in this regard.

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