Liquidity and solvency ratios are crucial tools for assessing a company's financial health. These metrics help gauge a firm's ability to meet short-term obligations and long-term commitments, providing insights into its financial stability and risk profile.

Profitability and market ratios offer a window into a company's efficiency and investor appeal. These measures evaluate a firm's ability to generate profits and its attractiveness to investors, helping stakeholders make informed decisions about the company's performance and potential.

Liquidity and Solvency Ratios

Liquidity ratios for short-term obligations

• Liquidity ratios gauge a company's capacity to settle short-term liabilities using current assets (cash, inventory, receivables)
  • Current ratio = $\frac{Current\ assets}{Current\ liabilities}$
    • Reveals how many times current assets can cover current liabilities
    • Higher ratio implies better liquidity (2:1 is generally considered good)
  • Quick ratio (Acid-test ratio) = $\frac{Cash + Marketable\ securities + Accounts\ receivable}{Current\ liabilities}$
    • Excludes less liquid assets like inventories and prepaid expenses
    • Provides a more stringent assessment of liquidity than current ratio (1:1 is typically acceptable)
• Interpreting liquidity ratios involves comparing them to industry norms and rivals and examining trends to spot changes in liquidity
  • A declining current ratio may signal potential difficulties in meeting short-term obligations
  • Consistently high quick ratio suggests efficient management of current assets and liabilities

Solvency ratios for financial stability

• Solvency ratios assess a company's ability to meet long-term commitments and its reliance on debt financing
  • Debt-to-equity ratio = $\frac{Total\ debt}{Total\ equity}$
    • Compares the amount of debt financing to equity financing
    • Higher ratio indicates greater financial risk and leverage (generally should not exceed 2:1)
  • Interest coverage ratio = $\frac{Earnings\ before\ interest\ and\ taxes\ (EBIT)}{Interest\ expense}$
    • Measures a company's ability to make interest payments on outstanding debt
    • Higher ratio suggests better capacity to meet interest obligations (3:1 or higher is desirable)
• Interpreting solvency ratios
  • High debt-to-equity ratio may signal increased financial risk and difficulty securing additional financing
  • Low interest coverage ratio may indicate challenges in servicing debt and higher risk of default
  • Solvency ratios help creditors and investors gauge a company's financial stability and long-term viability

Profitability and Market Ratios

Profitability ratios for efficiency evaluation

• Profitability ratios measure a company's ability to generate profits relative to its revenue, assets, or equity
  • Gross profit margin = $\frac{Gross\ profit}{Net\ sales}$
    • Calculates the percentage of revenue left after deducting cost of goods sold
    • Higher margin indicates better pricing power and cost control (varies by industry)
  • Operating profit margin = $\frac{Operating\ income}{Net\ sales}$
    • Measures the percentage of revenue remaining after deducting operating expenses
    • Reflects a company's operational efficiency and ability to generate profits from core business activities
  • Return on equity (ROE) = $\frac{Net\ income}{Average\ shareholders'\ equity}$
    • Assesses the profitability generated from shareholders' invested capital
    • Higher ROE indicates better efficiency in generating profits from equity (15-20% is generally considered good)
• Interpreting profitability ratios involves comparing them to industry benchmarks and historical performance and analyzing trends to identify improvements or declines in profitability
  • Consistently high gross profit margin suggests a competitive advantage in pricing or production efficiency
  • Declining operating profit margin may indicate rising costs or intensifying competition

Market ratios for investor attractiveness

• Market ratios relate a company's stock price to its financial performance and cash flows to assess valuation and investor appeal
  • Price-to-earnings (P/E) ratio = $\frac{Market\ price\ per\ share}{Earnings\ per\ share}$
    • Shows how much investors are willing to pay for each dollar of earnings
    • Higher P/E ratio suggests higher growth expectations or potential overvaluation (varies by industry and market conditions)
  • Dividend yield = $\frac{Annual\ dividends\ per\ share}{Market\ price\ per\ share}$
    • Measures the cash return to investors in the form of dividends
    • Higher yield may attract income-oriented investors (typically 2-5% is considered attractive)
• Interpreting market ratios
  • Comparing P/E ratio to industry peers and market averages helps assess relative valuation and growth prospects
  • Dividend yield should be considered in the context of a company's dividend policy, payout ratio, and growth opportunities
  • Market ratios help investors make informed decisions based on a company's valuation and potential returns