Uses of Investment Ratios
Companies use investment metrics to evaluate their economic success and operating performance. These indicators help ease the fears of investors and regulators, especially financial-market participants who buy equity stakes with a long-term perspective. Investors' fears may result from decreases in corporate sales, declining economic conditions or the specter of bankruptcy.
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Profitability
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A company's leadership relies on profitability ratios to gauge its financial health, making sure the company is winning the economic competition in the marketplace. These metrics also help investors set profitable companies apart from firms that have sluggish sales. Profitability ratios include gross profit margin and return on equity. Gross profit margin equals total sales minus costs of goods sold divided by total sales. The ratio indicates how efficiently a firm manages its materials costs compared to the competition. Return on equity equals net income divided by equity capital and indicates how much shareholders make on each dollar invested in a business.
Efficiency
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Efficiency indicators tell the tale of a company's operating prowess, with a special emphasis on how department heads and segment leaders manage day-to-day activities and work streams. Top management relies on the work of business unit chiefs to measure the effectiveness and efficiency of strategic, long-term decisions. Efficiency ratios include accounts-receivable-turnover ratio and inventory-turnover ratio. Accounts-receivable-turnover ratio equals total net sales divided by accounts receivable and indicates how quickly a firm collects customer payments. Inventory-turnover ratio indicates how quickly a company sells goods and replenishes stocks. This metric equals cost of goods sold divided by inventories.
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Safety
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Securities-exchange players take a look at safety ratios to familiarize themselves with risks implicit in corporate activities. Examples include EBIT-to-interest ratio and debt-to-interest ratio. By dividing "earnings before interest and taxes" by interest, investors evaluate whether a company generates enough revenue to cover interest payments. Debt-to-equity ratio equals total debt divided by total shareholders' equity capital. The metric measures whether a firm has enough equity capital to repay its debt, indicating to investors the firm's ability to withstand financial distress.
Liquidity
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Liquidity metrics enable corporate leaders to answer a simple question: Does the business generate enough cash to fund short-term operations and expand in the long term? With these ratios, department heads appraise financing needs in business units and make effective cash-allocation decisions. Liquidity ratios include current ratio and working capital. Current ratio equals short-term assets divided by short-term liabilities and indicates a firm's ability to make debt payments within 12 months. Short-term resources include cash, inventories and accounts receivable. Working capital measures the firm's cash balance in the short term and equals short-term assets minus short-term liabilities.
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