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There are four categories of financial ratios: profitability, liquidity, solvency and valuation.

Profitability ratios reveal how likely it is a company will turn a profit. One example is the profit margin, which is net income divided by revenue. Higher profit margins are better, but a company’s profit margin should be compared to past levels, to the market average, and to competitors.

Liquidity ratios measure how quickly assets can be converted to cash to buy assets or repay creditors. One example is the receivables turnover ratio, which is net credit sales divided by average accounts receivable. This is the number of times in the period that a company collects payments it’s owed. Like most ratios, it works best when compared to others in the industry.

A company without a lot of debt is a better investment than one that’s weighed down by it. Investors use solvency ratios to see how well a company can cope with long-term financial obligations.

The total debt to total assets ratio divides short and long-term debt by total assets. Numbers close to zero are generally better, but young companies may be close to 1 because they have yet to pay off much debt.

And valuation ratios analyze an investment’s appeal, revealing how cheap or expensive a company’s current stock price is. The less expensive a company is, the more attractive of an investment it usually is.

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