Financial Ratios


Some important financial ratios

However, its importance and applicability depends upon the kind of activity to be undertaken and finance being sought.

A. Liquidity Analysis

Liquidity Ratios measure a company’s ability to meet its maturing short-term obligations. In other words, can a company quickly convert its assets to cash without a loss in value if necessary to meet its short-term obligations? They are also a key predictor of a company’s ability to make timely payments to creditors and to continue to meet obligations to lenders when faced with an unforeseen event.

Ratios Formula Description
Current Ratio Current Assets / Current Liabilities This ratio reflects the number of times short-term assets cover short-term liabilities and is a fairly accurate indication of a company's ability to service its current obligations. A higher number (atleast 1.25:1) is preferred because it indicates a strong ability to service short-term obligations.
Quick Ratio (Current Assets-inventories-prepaid expenses)/Current Liabilities This ratio, also known as the acid test ratio, measures immediate liquidity - the number of times cash, accounts receivable, and marketable securities cover short-term obligations. A higher number (ideal 1:1) is preferred because it suggests a company has a strong ability to service short-term obligations. This ratio is a more reliable variation of the Current ratio because inventory, prepaid expenses, and other less liquid current assets are removed from the calculation.
Defensive Interval Days QUICK ASSETS/AVERAGE DAILY CASH OPERATING EXPENSES i.e. (Current Assets-inventories-prepaid expenses) / (Operating Expenses - Other Expenses - Interest Expense - Provision for Income Taxes - Amortization Expense) / Days) This ratio gauges the threat of insolvency for investors by calculating the number of days a company can operate without any cash returns while meeting its basic operational costs.
Accounts Receivable to Working Capital Trade Accounts Receivable / (Current Assets - Current Liabilities) This ratio measures the dependency of working capital on the collection of receivables. A lower number for this ratio is preferred, indicating that a company has a satisfactory level of working capital and accounts receivable makes up an appropriate portion of current assets.
Inventory to Working Capital Inventory / (Current Assets - Current Liabilities) This ratio measures the dependency of working capital on inventory. A lower number for this ratio is preferred indicating that a company has a satisfactory level of working capital and inventory makes up a reasonable portion of current assets.
Sales to Working Capital Sales / (Current Assets - Current Liabilities) This ratio measures a company's ability to finance current operations. Working capital (current assets-current liabilities) is another measure of liquidity and the ability to cover short-term obligations. This ratio relates the ability of a company to generate sales using its working capital to determine how efficiently working capital is being used. In general, a lower number is preferred because it indicates a company has a satisfactory level of working capital. However, an exceptionally low number may indicate inadequate sales levels are being generated.
Activity Analysis Sales / (Current Assets - Current Liabilities) This ratio measures a company's ability to finance current operations. Working capital (current assets-current liabilities) is another measure of liquidity and the ability to cover short-term obligations. This ratio relates the ability of a company to generate sales using its working capital to determine how efficiently working capital is being used. In general, a lower number is preferred because it indicates a company has a satisfactory level of working capital. However, an exceptionally low number may indicate inadequate sales levels are being generated.
Days Sales in Receivables Trade Accounts Receivable / (Sales / Days) This ratio measures the average number of days a company's receivables are outstanding. A lower number of days is desired. An increase in the number of days receivables are outstanding indicates an increased possibility of late payment by customers. Companies should attempt to reduce the number of days sales in receivables in order to increase cash flow.
Inventory Turnover COST OF GOODS SOLD /AVERAGE INVENTORY This ratio measures the velocity of conversion of stock into sales. A higher number is preferred because it indicates efficient management of inventory.
Operating Cycle Days (Inventory / (Cost of Sales / Days)) + (Trade Accounts Receivable / (Sales / Days)) This ratio calculates the total conversion period for a company, or in other words, the average number of days it takes to convert inventory into cash from sales. It is calculated by adding together the days cost of sales in inventory to the days sales in receivables. Evaluating this ratio can be helpful in gauging the effectiveness of marketing, determining credit terms to extend to customers, and collecting outstanding accounts.
Sales to Assets Sales / Total Assets This ratio measures a company's ability to produce sales in relation to total assets to determine the effectiveness of the company's asset base in producing sales. A higher number is preferred, indicating that a company is using its assets to successfully generate sales. This ratio does not take into account the depreciation methods employed by each company and should not be the only measure of effectiveness of a company in this area.
Percent Accumulated Depreciation to Fixed Assets Accumulated Depreciation / Property and Equipment * 100 This ratio measures the cumulative percentage of productive asset costs a company has allocated to operations.
Net Fixed Assets to Equity (Property and Equipment - Accumulated Depreciation) / Total Equity This ratio measures the extent to which investors' capital was used to finance productive assets. A lower ratio indicates a proportionally smaller investment in fixed assets in relation to net worth, which is desired by creditors in case of liquidation.

B. Profitability Analysis

Profitability ratios measure a company’s ability to use its capital or assets to generate profits. Improving profitability is a constant challenge for all companies and their management. Evaluating profitability ratios is a key component in determining the success of a company.

Ratios Formula Description
Percent Gross Profit ((Sales - Cost of Sales) / Sales) * 100 This ratio measures the gross profit earned on sales and reports how much of each sales dollar is available to cover operating expenses and contribute to profits.
Percent Profit Margin on Sales Earnings before Taxes / Sales * 100 This ratio measures how much profit a company makes on each sales dollar received and how well a company could potentially deal with higher costs or lower sales in the future.
Percent Rate of Return on Assets Earnings before Taxes / Total Assets * 100 This ratio measures how effectively a company's assets are being used to generate profits. It is one of the most important ratios when evaluating the success of a business. A higher number reflects a well-managed company with a healthy return on assets.
Percent Rate of Return on Equity Earnings before Taxes / Total Equity * 100 This ratio expresses the rate of return on equity capital employed and measures the ability of a company's management to realize an adequate return on the capital invested by the owners in a company. A higher number is preferred for this commonly analyzed ratio.

C. Coverage ratios Analysis

Coverage ratios assess a company’s ability to meet its long-term obligations, remain solvent, and avoid bankruptcy. It measures how well a company’s cash flow covers its short-term financial obligations.

Lenders evaluate coverage ratios to determine the degree to which a company could become vulnerable when faced with economic downturns. A company with a high level of debt poses a higher risk to long-term creditors and investors.

Ratios Formula Description
Debt to Total Assets Total Liabilities / Total Assets This ratio measures what proportion of debt a company is carrying relative to its assets. A ratio value greater than one indicates a company has more debt than assets. Companies and creditors prefer a lower number.
Percent Owners Equity Total Equity / Total Assets * 100 This ratio measures what proportion of total assets was provided by the owners equity. The higher the number the more total capital has been contributed by owners and the less by creditors.
Equity Multiplier Total Assets / Total Equity This ratio measures the extent to which a company uses debt to finance its assets. The higher the number is, the more a company is relying on debt to finance its assets.
Debt to Equity Total Liabilities / Total Equity This ratio measures the financial leverage of a company by indicating what proportion of debt and equity a company is using to finance its assets. A lower number suggests there is both a lower risk involved for creditors and strong, long-term, financial security for a company.
Times Interest Earned Earnings before Interest and Taxes / Interest Expense This ratio measures a company's ability to meet interest payments. A higher number is preferred, suggesting a Company can easily meet interest obligations and can potentially take on additional debt

D. Expense to sales ratios

Expense to sales ratios expresses specific expense items as a percentage of net sales. Comparisons of expenses are more meaningful because net sale is used as a constant.

Ratios Formula Description
Percent Depreciation to Sales Depreciation Expense / Sales * 100 This ratio measures depreciation expense as a percentage of sales and is based on a company's fixed assets and how quickly they are being depreciated or amortized, relative to sales.