Financial Ratios

LESSON 5-1 FINANCIAL RATIOS

Lesson Objectives

• appreciate the use of ratios as a financial tool

• define liquidity ratios

• define solvency ratios

• define profitability ratios

Financial ratios can be used to compare a company's current financial position and performance
with those of past years and identify strengths and weaknesses. It also allows comparison of
different companies in different industries. Their use is not only limited to management but to
stockholders and creditors as well. Some creditors or financial institutions require the
presentation of certain ratios before they extend credit. This is to ascertain the return of their
money together with the interest.

In the process of using financial ratios to evaluate a company, ratios are often divided
into four categories as follows:

a. Liquidity - is the ability of the company to settle its current obligations as they fall due.
b. Solvency - is the ability of the company to settle its non-current or long term obligations
and the interest related to these obligations
c. Profitability - measures the company's operating performance as a return on its
investment. It gauges management's efficiency in using company resources in order to
generate revenue.
d. Market Value or Valuation - measures the company's potential for future earnings,
dividend payments and stock price growth

For purposes of this course, market value or valuation will not be discussed in this book as
lessons on dividends and stocks have not yet been introduced to the students.