Financial ratios are important factors for financial service industry as the same are used by business owners to measure performance of a business. Financial ratios are also important to business lenders by which they can make a risk assessment and examine performance of loans. There are many types of financial ratios that by lenders and small business owners use. The most important types of financial ratios are:

  • Liquidity Ratios
  • Profitability Ratios
  • Debt Ratios Or Leveraging Ratios
  • Liquidity Ratios

The liquidity ratios signify whether a business is able to meet its current obligations from its current assets. Put it differently, liquidity ratios assess a business ability to use its current assets (cash, accounts receivables, stock, and marketable securities) to pay off its current obligations (creditors, taxes, and current debt portion). The most general types of liquidity ratios are current ratio and quick ratio or acid test ratio. The current ratio is measured by dividing current assets by current liabilities. The quick ratio helps conclude a company’s capability to repay debts that become outstanding right away.

Other liquidity ratios include cash ratio and operating cash flow ratio.

  • Profitability Ratios

The profitability ratios signify the current business profitability and its trends. These ratios assist in evaluating a business overall performance in terms of revenue made on sales and investments.

Gross Profit Margin

The most general profitability ratio is gross profit margin or gross profit rate, which basically is the gross profit of a business calculated by gross profit divided by the net sales revenue. This ratio highlights the adequacy of price, stock costs and controls based upon the industry and production costs.

Operating Profit Margin

Second common type is the operating profit margin ratio which measures the operating costs like administration, advertising, tenancy costs and detailing whether a business is making sufficient sales to cover expenses.

Net Profit Margin

The third most common type is the net profit margin ratio often referred to as the bottom line and takes into account all other expenses and costs.

Other profitability ratios include return on equity (ROE), return on assets (RAO), Return on net Assets (RONA), return on capital (ROC), return on capital employed (ROCE), cash flow return on investment (CFROI), and efficiency ratio.

  • Debt Ratios or Leveraging Ratios

Debt ratios help conclude risk to the lender and to the business depend upon the business capitalization and its cash flow in regard to its debts. The debt ratio is calculated by dividing the total liabilities by the total assets. The debt ratio provides signify financial steadiness of a business. The total assets shouldn’t include significant amount of intangible assets like goodwill so as to avoid any misleading results.

Another important debt ratio is debt service coverage ratio which is calculated by dividing operating cash flow with debt payments. This ratio calculates a business ability to pay off its debt payments. Generally, banking institution frequently use leverage ratios as debt conventions in contract agreements. This way they make sure the business sustain operations even in difficult financial times.

Other debt ratios include debt to equity ratio, long term debt to equity, interest coverage ratio, and debt service coverage ratio.