BUSINESS
IV-A: TYPES OF FINANCIAL RATIOS
LIQUIDITY RATIOS
Liquidity is a measure of the quality and adequacy of
current assets to meet current obligations as they come due.
Computation Total current assets divided by total current
liabilities.
TOTAL CURRENT ASSETS__
TOTAL CURRENT LIABILITIES
Interpretation This ratio is a rough indication of a firm's
ability to service its current obligations.
Generally, the higher the current ratio, the greater the "cushion"
between current obligations and a firm's ability to pay them. The stronger ratio reflects a numerical
superiority of current assets over current liabilities. However, the composition and quality of
current assets is a critical factor in the analysis of an individual firm's
liquidity.
Computation Current assets minus inventory divided by
total current liabilities.
CURRENT ASSETS - INVENTORY
TOTAL CURRENT LIABILITIES
Interpretation Also known as the "ACID TEST" ratio,
it is a refinement of the current ratio and is a more conservative measure of
liquidity. The ratio expresses the
degree to which a company's liabilities are covered by the most liquid current
assets. Generally, any value of less
than 1:1 implies a dependency on inventory to liquidate short-term debt. The ratio values are always positive.
NET WORKING CAPITAL TURNOVER
Computation Net sales
divided by net working capital (current assets less current liabilities equals
net working capital).
NET SALES______
NET WORKING CAPITAL
Interpretation Working capital is a measure of the margin of
protection for current creditors. It
reflects the ability to finance current operations. Relating the level of sales arising from operations to the
underlying working capital measures how efficiently working capital is
employed. A low ratio may indicate an
inefficient use of working capital while a very high ratio often signifies
overtrading (vulnerable position for creditors). If working capital is negative, the quotient will be negative.
Computation Net sales divided by net trade receivables.
NET SALES_______
TRADE RECEIVABLES (NET)
Interpretation This ratio measures the number of times trade
receivables turn over during the year. The higher the turnover of receivables,
the shorter the time between sale and cash collection. If a company's receivables appear to be
turning slower than the rest of the industry, further research is needed and
the quality of the receivables should be examined closely. A problem with this ratio is that it
compares one day's receivables, shown at statement date, to total annual sales
and does not take into consideration seasonal fluctuations.
Computation The receivable turnover ratio divided into
365 (the number of days in one year).
TRADE RECEIVABLES (NET) X 365
NET SALES
Interpretation This figure expresses the average time in days
that receivables are outstanding.
Generally, the greater number of days outstanding, the greater the
probability of delinquencies in accounts receivable. A comparison of a company's daily receivables may indicate the
extent of a company's control over credit and collections. The terms offered by a company to its
customers, however, may differ from terms within the industry and should be
taken into consideration.
Computation Cost of sales divided by inventory.
COST OF SALES
INVENTORY
Interpretation This ratio measures the number of times
inventory is turned over during the year.
High inventory turnover can indicate better liquidity or superior
merchandising. Conversely, it can
indicate a shortage of needed inventory for sales. Low inventory turnover can indicate poor liquidity, possible
overstocking, obsolescence, or in contrast to these negative interpretations a planned
inventory buildup in the case of material shortages. A problem with this ratio is that it compares one day's inventory
to annual cost of goods sold and does not take seasonal fluctuations into
account.
Computation Inventory turnover ratio divided into 365
(the number of days in one year).
INVENTORY
X 365__
COST OF SALES
Interpretation Division of the inventory turnover ratio into
365 days yields the average length of time units are in inventory.
Computation Net sales divided by net fixed assets (net of
accumulated depreciation).
NET SALES_ __
NET
FIXED ASSETS
Interpretation This ratio is a measure of the productive use
of a firm's fixed assets. Largely
depreciated fixed assets or a labor intensive operation may cause a distortion
of this ratio. This ratio cannot be
calculated if fixed assets are zero and the ratio values cannot be negative.
Computation Net sales divided by total assets.
NET SALES__
TOTAL ASSETS
Interpretation This ratio is a general measure of a firm's
ability to generate sales in relation to total assets. It should be used only to compare firms
within specific industry groups and in conjunction with other ratios to
determine the effective employment of assets.
Computation Cost of sales divided by trade payables.
COST OF SALES_
TRADE PAYABLES
Interpretation This ratio measures the number of times trade
payables turn over during the year. The
higher the turnover, the shorter the time between purchases and payments. If a company's payables appear to be turning
more slowly than the industry, then the company may be experiencing cash
shortages, disputing invoices with suppliers, enjoying extended terms, or
deliberately expanding its trade credit.
A problem with this ratio is that it compares one day's payables to
annual cost of goods sold and does not take seasonal fluctuations into
account.
Computation The payables turnover ratio divided into 365
(the number of days in one year).
PAYABLE X 365_
COST
OF SALES
Interpretation Division of the payables turnover ratio into
365 days yields the average length of time trade debt is outstanding.
Computation Total debt divided by total assets.
TOTAL DEBT_
TOTAL ASSETS
Interpretation This ratio expresses the relationship between
capital contributed by creditors and total assets (financed by creditors and
contributed by owners). It states the
percent of assets financed by debt; looking at it another way, the ratio states
the amount of debt to each dollar of assets.
Computation Earnings
(profit) before annual interest expense and taxes divided by annual interest
expense.
EARNINGS BEFORE INTEREST & TAXES
ANNUAL INTEREST EXPENSE
Interpretation This ratio is a measure of a firm's ability to
meet interest payments. A high ratio
may indicate that a company would have little difficulty in meeting the
interest obligations of loans. This
ratio also serves as an indicator of a firm's capacity to take on additional
debt.
PROFITABILITY RATIOS
Computation The profit margin on sales is computed by
dividing net income after taxes by sales.
NET INCOME
SALES
Interpretation This ratio gives the profit per dollar of
sales.
RETURN ON ASSETS (ROA)
Computation The ratio of net income available to common
stockholders to total assets.
NET INCOME_
TOTAL ASSETS
Interpretation This ratio measures the rate of return (after
interest and taxes) on total assets.
The ratio is useful for comparing prior years' rate of return with the
current year's; however, it is not very useful for making inter-firm
comparisons because it is sensitive to differences in capital structure.
RETURN ON EQUITY (ROE)
Computation The ratio of net income available to common
stockholders to common equity.
NET INCOME__
COMMON EQUITY
Interpretation This ratio measures the rate of return on the
common stockholders' investment. The
ratio is useful for both intra-company and inter-firm comparisons.
Computation Cash flow from
operating activities plus interest expense divided by interest expense.
CASH
FLOW FROM OPERATING ACTIVITIES + INTEREST
INTEREST
Interpretation This ratio is similar to the Times Interest
Earned ratio; however, in this case the ratio measures the firm's ability to
meet interest payments from cash flow.
This ratio is a more realistic measure than Times Interest Earned.
Computation Cash flow from operating activities minus
preferred dividends divided by earning available for common stockholders.
CASH
FLOW FROM OPERATING ACT. - PREFERRED DIVIDEND
EARNING AVAILABLE FOR COMMON STOCKHOLDERS
Interpretation This ratio shows the amount of cash flow
dollars available to common stockholders for each dollar of net income after
preferred dividend. A number greater
than one indicated strength in the form of company cash flow.