# Ratios for Financial Statement Analysis

Ratio analysis is a primary analytical technique that when used properly is an effective way to evaluate a company’s financial standing. A key to the proper execution of ratio analysis is the employment of a variety of ratios to give a balanced view of the company existence. These ratios include profitability, activity, liquidity and cash flow.

## Profitability Ratios

Profitability ratios measure a particular aspect of management’s operating efficiency. Three different ratios are used to evaluate management’s performance and help answer the following questions.

• How effective is management in employing assets profitably?
• How successful is management in maximizing the return on owners’ investments?
• How well has management done with the profit generated on sales?

## Activity Ratios

Whereas profitability ratios determined management’s effectiveness in generating profit, activity ratios evaluate management’s effectiveness in using the profit/assets. To calculate an activity ratio, an asset is divided into the best measure of that asset’s activity. For example, for accounts receivable, the best measure of asset activity is sales.

## Liquidity Ratios

The purpose of liquidity ratios is to determine the company’s ability to pay its short-term obligations. Two ratios are utilized to do so.

• Current ratio: The ratio defines the relationship between current assets and current liabilities.
• Quick or acid test ratio: This ratio is calculated like a current ratio except inventory is removed from current assets because inventory is usually not directly convertible to cash.

## Cash Flow Ratios

The employment of cash flow ratios examine the adequacy of a company’s cash flows and the quality of its earnings. The cash flow ratio determines the extent to which cash flow from operations is enough for the company’s investing and financing activities.

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