Financial Ratios
Liquidity Ratios
• Current ratio :
•
•
•
•
Usually a minimum is 2.0
However, it varies between industries and economic conditions.
A high ratio (e.g., > 5) indicates assets are not efficiently used.
A low ratio (below industry average) indicates liquidity problems
Liquidity Ratios
• Acid Test Ratio:
• Since inventory is more difficult to liquidate, it is removed here
• Again, it varies between industries and economic conditions.
4
Leverage Ratio
• ‘Gearing’ Ratio:
Debt-to-Assets Ratio
=
Total Debt
Total Assets
• Shows how much funding comes from debt.
• For example, if Company XYZ had $10 million of debt on its balance sheet
and $15 million of assets, then Company XYZ's debt ratio is:
Debt Ratio = $10,000,000 / $15,000,000 = 0.67 or 67%
This means that for every dollar of Company XYZ assets, Company XYZ had
$0.67 of debt. A ratio above 1.0 indicates that the company has more debt
than assets.
Activity Ratios
• These ratios show how effectively a
company is using its resources. Some of
these ratios are:
Inventory Turnover
=
Cost of Goods Sold
Inventory
• Result indicates how many times per year we sell all inventory.
• The higher the number the better
• If the result above is (for example) 3, that means we ‘turnover’ our
inventory 3 times per year. That is, every 4 month we get new
inventory
6
Activity Ratios
Asset Turnover
• A measure of how well the company is using its assets to generate
sales.
• The higher the number the better
Asset Turnover
=
Net Sales
Total Assets
7
Activity Ratios
Accounts Receivable Turnover
• A measure of how well the company is getting its accounts
receivable from the market.
• The higher the number the better
Accounts Receivable Turnover
=
Net Sales
Accounts Receivable
• Again, a number of ‘3’ means we are renewing (turning over) our
Accounts Receivable 4 times a year
8
Profitability Ratio
Profit Margin
• A ratio of Net Income versus Sales
• The higher the number the better
Profit Margin
=
Net Income
Net Sales
• Usually a value of 8 – 10% is acceptable. For some businesses it
can be around 2 – 3%
• Net sales is calculated by subtracting any returns or refunds from
gross sales. Net income equals total revenues minus total
expenses and is usually the last number reported on the income
statement.