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Financial ratio analysis: liquidity, solvency and profitability ratios

How should financial ratio analysis: liquidity, solvency and profitability ratios be measured and interpreted?

AccessibleStrategicOrganisation2 min read

Contents

Financial ratios help to analyse the financial performance of all the activities of an organisation and all its products and services in all markets.

Financial ratio analysis relates figures from financial statements to show liquidity, solvency, profitability and operating efficiency. Ratios make organisations, periods and business units easier to compare, while revealing financial constraints that may affect a proposed strategy.

When to use it

Review ratios as part of regular management reporting and whenever an investment, financing decision or strategic initiative could materially change the financial position.

Use consistent definitions to compare the organisation with its history, plan and relevant peers. Where the underlying data support it, calculate ratios by product, market or business unit—but remember that shared costs and internal allocations can distort those views.

Liquidity

Current ratio = \frac{Current assets}{Current liabilities}

Quick ratio = \frac{Current assets - Inventory}{Current liabilities}

Cash ratio = \frac{Cash}{Current liabilities}

Solvency

Total debt ratio = \frac{Total assets - Total equity}{Total assets}

Debt-equity ratio = \frac{Total debt}{Total equity}

Equity multiplier = \frac{Total assets}{Total equity}

Times interest earned ratio = \frac{EBIT}{Interest}

Profitability

Profit margin = \frac{Total income}{Total assets}

Return on assets (ROA) = \frac{Net income}{Total assets}

ROA = \frac{Net income}{Sales} \times \frac{Sales}{Assets} \times \frac{Assets}{Equity}

Activity

Inventory turnover = \frac{Cost of goods sold}{Inventory}

Days’ sales in inventory = \frac{Cost of goods sold}{Inventory}

Days’ sales in receivables = \frac{365 days}{Receivables turnover}

Total asset turnover = \frac{Sales}{Total assets}

A ratio review helps assess:

the current financial condition;
the capacity to meet obligations and attract capital;
the headroom available for further investment.

Origins

Ratio analysis evolved from double-entry accounting, published financial statements and the needs of lenders and investors rather than from a single inventor. Commercial analysts began comparing balance-sheet and income-statement figures systematically as corporate reporting expanded. In the early twentieth century, the DuPont system demonstrated how linked ratios could decompose return on equity into operating margin, asset use and leverage. Modern analysis retains that comparative logic across a wider set of measures.

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When to use it

Origins

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