Profitability Ratios
Profitability Ratios
Profitability Ratios attempt to measure the firm's success in generating income. These ratios reflect the combined effects of the firm's asset and debt management.
Profit Margin
The Profit Margin indicates the dollars in income that the firm earns on each dollar of sales. This ratio is calculated by dividing Net Income by Sales.
Return on Assets (ROA) and Return on Equity (ROE)
The Return on Assets Ratio indicates the dollars in income earned by the firm on its assets and the Return on Equity Ratio indicates the dollars of income earned by the firm on its shareholders' equity. It is important to remember that these ratios are based on Accounting book values and not on market values. Thus, it is not appropriate to compare these ratios with market rates of return such as the interest rate on Treasury bonds or the return earned on an investment in a stock.
Short-term Solvency or Liquidity Ratios
Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial distress in the short-run. The two most important Short-term Solvency Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid-Test Ratio.)
Current Ratio
The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are the assets that the firm expects to convert into cash in the coming year and Current Liabilities represent the liabilities which have to be paid in cash in the coming year. The appropriate value for this ratio depends on the characteristics of the firm's industry and the composition of its Current Assets. However, at a minimum, the Current Ratio should be greater than one.
Quick Ratio
The Quick Ratio recognizes that, for many firms, Inventories can be rather illiquid. If these Inventories had to be sold off in a hurry to meet an obligation the
Profitability Ratios attempt to measure the firm's success in generating income. These ratios reflect the combined effects of the firm's asset and debt management.
Profit Margin
The Profit Margin indicates the dollars in income that the firm earns on each dollar of sales. This ratio is calculated by dividing Net Income by Sales.
Return on Assets (ROA) and Return on Equity (ROE)
The Return on Assets Ratio indicates the dollars in income earned by the firm on its assets and the Return on Equity Ratio indicates the dollars of income earned by the firm on its shareholders' equity. It is important to remember that these ratios are based on Accounting book values and not on market values. Thus, it is not appropriate to compare these ratios with market rates of return such as the interest rate on Treasury bonds or the return earned on an investment in a stock.
Short-term Solvency or Liquidity Ratios
Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial distress in the short-run. The two most important Short-term Solvency Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid-Test Ratio.)
Current Ratio
The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are the assets that the firm expects to convert into cash in the coming year and Current Liabilities represent the liabilities which have to be paid in cash in the coming year. The appropriate value for this ratio depends on the characteristics of the firm's industry and the composition of its Current Assets. However, at a minimum, the Current Ratio should be greater than one.
Quick Ratio
The Quick Ratio recognizes that, for many firms, Inventories can be rather illiquid. If these Inventories had to be sold off in a hurry to meet an obligation the