What Are Ratios and Why Do They Matter?

Define Ratios

Ratios are a very common and widely used concept. They are used in almost every field. They are an easy way to draw a comparison between two figures. As an Entrepreneur, Financial ratios should be your main concern. They are a kind of financial analysis, used for comparison as well as for drawing interrelationship between two figures. These financial ratios consist of activity ratios, efficiency ratios, investment ratios, asset turnover ratios, dividend policy ratios, leverage ratios, profitability ratios and much more. There are different ways in which you can compare figures on your balance sheet or figures from the market. These ratios allow you to compare between industries, companies, different time periods for one company and a company with respect to an industry or a market. Now, that you have a fair idea of what ratios or better financial ratios imply, you may ask why do they matter? Same is discussed below with different financial ratios in detail.

Ratios matter because they are the best way to draw a comparison or make out a relation between two figures. Any financial analysis doesn't allow you to compare two figures, that is why ratios are important. They let you compare. This way you can understand different aspects of your company. You can even know the position in which your company is standing with respect to other companies, industries, and markets. Hence, making you realize your position and giving you a fair idea of where improvements are required.

Now, let's have a look at some different types of ratios;

Liquidity Ratios: They are the kind of ratios which represent the short-term financial status of a company. Ratios include Current ratio, Quick ratio, and Cash ratio. The current ratio is also known as a working capital ratio. It is the ratio of current assets relative to the current liabilities of the company. A high current ratio is desired by company owners. It keeps them out of any kind of financial risk in the near future. The quick ratio is the ratio of current assets minus the inventory by the current liabilities. Cash ratio refers to the ratio of cash plus marketable securities by the current liabilities. However, it is very rarely used. It shows the ability of the company to pay off current liabilities.

Asset Turnover Ratios: These ratios state the company's status regarding its assets. They are also known as efficiency ratios. They include Receivables turnover, Average collection period, Inventory turnover and Inventory period. These ratios as the name suggests are ratios which use accounts receivables and average inventory as figures.

Financial Leverage Turnover: This ratio shows the long-term financial status of a company. This includes debt ratio, debt-to-equity ratio, and interest coverage. Debt Ratio is the ratio between total debt and total assets, giving an overview of the paying capability of a company to clear off its debt. Debt-to-equity ratio as the name suggests is the ratio between the total debt and the total equity.

Profitability Ratios: These ratios indicate the profit making capability of a company. They include Gross Profit margin, Return on assets, Return on equity. All these ratios give a fair idea of how successful a company is in terms of making profits.

Dividend Policy ratios: These ratios measure how much a company pays out in dividends relative to its earnings and market value of its shares. They include Dividend yield which is the ratio between dividends per share and share price and the other ratio is Dividend Payout Ratio. The payout ratio is the ratio between dividends per share and earnings per share.

All these ratios together give a good comparison as well as the general financial status of a company. You can use these ratios in many places. Planning and Forecasting are carried out on the basis of ratios. Ratios help you rectify many loopholes.