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I’ve heard about financial ratios, but I don’t understand them. Can you explain?

Oct 28, 2009
Financial ratios are used to evaluate the financial fitness of your business. If you familiarize yourself with these ratios and monitor them regularly, you can better determine if your financial condition is improving or deteriorating.

Here are some of the more commonly used ratios and an explanation of the information they provide.

Profitability measures the returns on assets and equity. It tells you how efficiently your investment is earning income.

  • Gross profit margin = gross profit ÷ sales
  • Net profit margin = net income ÷ sales
  • Return on Equity (ROE) = net income ÷ equity
Liquidity measures your ability to pay short-term obligations.
  • Current ratio = Current assets ÷ current liabilities
  • Quick ratio = Current assets less inventory ÷ current liabilities
Leverage measures your degree of indebtedness and your ability to meet long-term obligations.
  • Debt ratio = total liabilities ÷ total assets
  • Debt to equity ratio = long-term debt ÷ equity
Activity measures your efficiency in generating sales with your assets.
  • Inventory turnover = cost of goods sold ÷ average inventory
  • Fixed asset turnover = sales ÷ net fixed assets
  • Total asset turnover = sales ÷ total assets