By the end of this lesson, you’ll be able to
A good way to evaluate the financial condition of a business is by using accounting ratios. They help to identify trends to take important business decisions. Commonly, there are the following five categories of ratios:
These are used to calculate how capable a company is of paying its debts. This is done by measuring current liabilities and liquid assets.
Some common liquidity ratios are:
1. Net Working Capital to Assets Ratio tells about the liquidity of business assets. An increasing net working capital ratio indicates that the business is investing more in liquid assets than fixed assets.
Net Working Capital Ratio = [Current Assets – Current Liabilities]/Total Assets
2. Current Ratio measures whether or not a company has enough resources to pay its debts over the next 12 months.
Current Ratio = Current Assets / Current Liabilities
3. Quick Ratio is a measure of a company’s ability to meet its short-term obligations using its most liquid assets (also known as ‘quick assets’). Quick assets include accounts receivable plus cash plus marketable securities.
Quick Ratio = Quick Assets/Current Liabilities
4. Cash Ratio or Cash Asset Ratio indicates the extent to which a company’s cash can pay off current liabilities. No other assets are considered in this ratio.
Cash Ratio = Cash / Current Liabilities
5. Cash Coverage Ratio calculates how likely it is that the business can pay interest on debts. It is similar to the cash ratio.
Cash Coverage Ratio = [Earnings Before Interest and Taxes + Depreciation] / Interest
6. Operating Cash Flow Ratio tells how current liabilities are covered by cash flow.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
These are used to measure a business’s earnings versus its expenses. Profitability is the capacity to make a profit. Profit is what is left over from income earned after deducting all costs and expenses related to earning the income. These are used to assess a company’s performance and to compare its performance against its competitors.
Common profitability ratios include
a. Gross Profit Margin (GPM) tells the amount of money left over from sales after deducting the cost of goods sold.
Gross Profit Margin (GPM) = [Net Sales – Cost of Goods Sold] / 100
b. Operating margin measures how much profit a company makes on a dollar of sales, after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. The higher the operating margin, the more profitable a company’s core business is.
Operating Margin = Operating income / Total revenue
c. Return on assets measures how effectively the company produces income from its assets.
Return on assets = [Net income / Assets]
d. Return on equity measures how much a company makes for each dollar that investors put into it.
Return on equity = [Net income / Shareholder investment]
e. Return on sales is a measure of how efficiently a company turns sales into a profit. It is also known as operating profit margin.
Return on sales = Operating Profit / Net Sales
f. Return on investment measures the gain or loss of investment.
Return on investment (ROI) = [Net Profit / Total Investment] × 100
These assess how much of the company’s capital comes from debt. Leverage ratios are similar to liquidity ratios, except that leverage ratios consider your totals, whereas liquidity ratios focus on your current assets and liabilities.
Common leverage ratios are
a. Debt-to-Equity Ratio measures your company’s leverage by comparing your liabilities, or debts, to your values as represented by your stakeholders’ equity.
Debt-to-Equity Ratio = Total Debt / Total Equity
b. Total Debt Ratio defines the total amount of debt relative to assets.
Total Debt Ratio = [Total Assets – Total Equity] / Total Assets
c. Long-Term Debt Ratio measures the percentage of the company’s total assets financed with long-term debt (debt for longer than a one-year period).
Long-Term Debt Ratio = Long-Term Debt / [Long-Term Debt + Total Equity]
These measures a company’s income against its assets. Some common turnover ratios are:
a. Inventory Turnover Ratio shows how much inventory you’ve sold in a year or other specified period.
Inventory Turnover Ratio = Costs of Goods Sold/Average Inventories
b. Assets Turnover Ratio is a good indicator of how good your company is at using your assets to produce revenue.
Assets Turnover Ratio = Net Sales / Average Total Assets
c. Accounts Receivable Turnover Ratio evaluates how quickly the company is able to collect funds from its customers.
Accounts Receivable Turnover Ratio =Sales /Average Accounts Receivable
d. Accounts Payable Turnover Ratio measures the speed at which a company pays its suppliers.
Accounts Payable Turnover Ratio = Total Supplier Purchases / [(Beginning Accounts Payable + Ending Accounts Payable)/2]
These deal with stocks and shares. These are used to determine if stocks are overpriced, underpriced or at par with the market. Market value ratios are used for making investment decisions in stocks of companies.
Some common market value ratios are:
a. Price-to-Earnings Ratio is used to reveal how much investors are paying for each dollar earned per stock.
Price-to-Earnings Ratio = Price Per Share/Earnings Per Share
b. Market-to-Book Ratio compares the company’s historic accounting value to the value set by the stock market.
Market-to-Book Ratio = Market Value Per Share/Book Value Per Share
