Financial ratios are essentially metrics that a business can use to measure it performance and that lenders use to assess risk and monitor performance of their commercial loans. There are several categories of financial ratios that are used by lenders and also valuable for businesses to monitor. The major categories measure liquidity, profitability, and debt ratios.
The liquidity ratios provide an indication of whether the business is able to pay its short term obligations from its current assets. These ratios include the current ratio, which measures current assets (cash, receivables, inventory, and marketable securities) in relation to current liabilities (accounts payable, taxes, and the current portion of term debt). A more accurate measure is the quick ratio, which only uses the liquid assets (basically the current assets, but excludes inventory and other assets that are not available to quickly turn into cash to meet obligations).
The profitability ratios as the name implies provide an indication as to the current profitability and trends of the business. These ratios include gross profit margin which essentially is the gross profit (sales revenue minus cost of goods sold or cost of sales) divided by the sales revenue. This ratio provides some insight as to the sufficiency of pricing, inventory costs and controls and depending upon the industry, production costs. The net profit margin factors in the impact operating expenses such as administrative, marketing, occupancy costs and provides an indication as to whether the company is managing its operating costs properly or generating sufficient sales to cover costs. Other measures such as return on assets and return on equity are used to help measure efficiency and for investment comparisons.
The debt ratios help determine risk to a lender and to the business based upon the capitalization of the business and its cash flow in relation to its debt payments. The debt ratio (the total liabilities divided by the assets) can provide an indication of the financial stability of the company. Although this can be misleading at times if the assets include a significant amount of intangible assets such as goodwill. The debt service coverage ratio (operating cash flow divided by debt payments) measures the ability of the business to meet its debt payments.
There are additional ratios and factors that businesses and lenders consider depending upon the type of business such as inventory, accounts receivable and accounts payable turnover rates and aging.