Liquidity ratio

3. Formulas
Under liquidity ratio there are several more ratios, which come into the picture for checking how
financially, sound a company is:
I. Current Ratio
II. Acid Test Ratio or Quick Ratio
III. Absolute Liquidity Ratio
IV. Basic Defense Ratio

I. Current Ratio
This ratio measures the financial strength of the company. Generally 2:1 is treated as the ideal ratio, but it
depends on industry to industry.
Formula: Current Assets/ Current Liability
Where,
A. Current Assets = Stock, Debtor, Cash and bank, receivables, loan and advances, and other current
assets.
B. Current Liability = Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current
liability

II. Acid Test Ratio or Quick Ratio:

This ratio is the best measure of the liquidity in the company. This ratio is more conservative than the
current ratio. The quick asset is computed by adjusting current assets to eliminate those assets which are
not in cash. Generally 1:1 is treated as an ideal ratio.
Formula: Quick Assets/ Current Liability
Where,
Quick Assets = Current Assets – Inventory – Prepaid Expenses

III. Absolute liquidity ratio:

This ratio measures the total liquidity available to the company. This ratio only considers marketable
securities and cash available to the company. This ratio only tests short-term liquidity in terms of cash,
marketable securities, and current investment.
Formula: Cash + Marketable Securities / Current Liability

IV. Basic Defense Ratio:

This ratio measures the no. of days a company can cover its Cash expenses without the help of additional
financing from other sources.
Formula: (Cash + Receivables + Marketable Securities) ÷ (Operating expenses +Interest + Taxes) ÷ 365
2

Asset management ratios

The inventory turnover ratio is one of the most important asset management or turnover ratios. If your
firm sells physical products, it is the most important ratio. Inventory turnover is calculated as follows:

Inventory turnover ratio = Net sales/Inventory = ____X

This means that you divide net sales, from the income statement, from the inventory figure on the
balance sheet and you get a number that is a number of times. That number signifies the number of times
inventory is sold and restocked each year. If the number is high, you may be in danger of stockouts. If it is
low, watch out for obsolete inventory.

Days' Sales in Inventory

The Days' Sales in Inventory ratio tells the business owner how many days, on average, it takes to sell
inventory. The usual rule is that the lower the DSI the better because it is better to have inventory sell
quickly than to have it sit on your shelves.

If you know your company's inventory turnover ratio, you can quickly calculate the Days' Sales in
Inventory ratio. This quick formula for calculating this ratio is the following:

Days' Sales in Inventory = 365 days/Inventory turnover = ____ Days

If you don't have the inventory turnover ratio, there is another formula you can use to calculate Days'
Sales in Inventory:

Days' Sales in Inventory = Inventory/Cost of Goods Sold X 365 = _____ Days

The value of your inventory will come from your latest balance sheet. The cost of goods sold is taken
from the income statement. This ratio measures the company's financial performance for both the owners
and the managers as it pertains to the turnover of inventory. Inventory turnover varies from industry to
industry. Generally, a lower number of days' sales in inventory is better than a higher number of days. It
will vary from industry to industry.

Average Collection Period

Average collection period is also called Days' Sales Outstanding or Days' Sales in Receivables. It
measures the number of days it takes a company to collect its credit accounts from its customers. A
lower number of days is better because this means that the company gets its money more quickly.
Average collection period varies from industry to industry, however. It is important that a company
compare its average collection period to other firms in its industry.
Here is the calculation for Average Collection Period:

365 days/Sales/Accounts Receivable = _____ Days

The sales figure comes from the income statement and the accounts receivablecomes from the balance
sheet.

Receivables Turnover

Receivables turnover is a ratio that works hand in hand with an average collection period to give the
business owner a complete picture of the state of the accounts receivable. Receivables turnover looks at
how fast we collect on our sales or, on average, how many times each year we clean up or totally collect
our accounts receivable. The calculation is as follows:

Receivables Turnover = Sales/Accounts Receivable = ____ times

Generally, the higher the receivables turnover, the better as it means you are collecting your credit
accounts on a timely basis. If your receivables turnover is low, you need to take a look at your credit and
collections policy and be sure they are on target.

Fixed Asset Turnover

The fixed asset turnover ratio looks at how efficiently the company uses its fixed assets, like plant and
equipment, to generate sales. If you can't use your fixed assets to generate sales, you are losing money
because you have those fixed assets. Property, plant, and equipment are expensive to buy and maintain. In
order to be effective and efficient, those assets must be used as well as possible to generate sales. The
fixed asset turnover ratio is an important asset management ratio because it helps the business owner
measure the efficiency of the firm's plant and equipment.

Here is the calculation for fixed asset turnover:

Fixed Asset Turnover = Sales/Net Fixed Assets = _____ times

Usually, the higher the number of times, the better. However, if the ratio is too high, your equipment is
probably breaking down because you are operating over capacity. If the number of times is too low as
compared to the industry or to previous years of firm data, then your firm is not operating up to capacity
and your plant and equipment is likely sitting idle.

Net Working Capital Turnover

The net working capital turnover ratio is an asset management ratio that is a "big picture" ratio. It
measures how hard our working capital is "working" for the firm. Working capital is what you have left
over after the company pays its short-term debt obligations. Generally, the higher the value of the ratio,
the better. The calculation is as follows:

Net Working Capital Turnover = Sales/Net Working Capital

Total Asset Turnover

The total asset turnover ratio is the asset management ratio that is the summary ratio for all the other
asset management ratios covered in this article. If there is a problem with inventory, receivables, working
capital, or fixed assets, it will show up in the total asset turnover ratio. The total asset turnover ratio
shows how efficiently your assets, in total, generate sales. The higher the total asset turnover ratio, the
better and the more efficiently you use your asset base to generate your sales.

Here is the calculation:

Total Asset Turnover = Sales/Total Assets = _____ times

When you analyze your asset management ratios, you can look at your total asset turnover ratio and if
there is a problem, you can go back to your other asset management ratios and isolate the problem.
Knowing your position regarding the efficiency of using assets to make sales is crucial to the success of
your firm.

Debt Ratio

Profitability Ratios Formula

#1 – How to Calculate Gross Profit Margin?
The formula for gross profit margin can be calculated by using the following steps:

 Step #1: Firstly, the sales revenue is taken from the profit and loss account.

 Step #2: Then, the cost of goods sold is calculated which is the summation of raw material

consumed, labor expense and other similar direct expense attributable to the manufacturing of

the product. All the information is easily available from the profit and loss account.

o Cost of Goods Sold = Raw Material Cost + Labor Expense + Other Direct Expense
  Step #3: Now, the gross profit is calculated by deducting the cost of goods sold from the sales

revenue.

 Step #4: Finally, the gross profit margin is calculated by dividing the gross profit by the sales

revenue and multiplied by 100%.

o Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue * 100%

#2 – How to Calculate Net Profit Margin?

The formula for Net Profit Margin can be calculated by using the following steps:

 Step #1: Firstly, the sales revenue is calculated as described above.

 Step #2: Then, the net profit (PAT) is captured which is categorically mentioned as a separate

line item in the profit and loss account.

 Step #3: Finally, the net profit margin is calculated by dividing the net profit (PAT) by the sales

revenue and multiplied by 100%.

o Net Profit Margin = PAT / Revenue * 100%

#3 – How to Calculate EBITDA Margin?

The formula for EBITDA Margin can be calculated by using the following steps:

 Step #1: Firstly, the sales revenue is calculated as described above.

 Step #2: Now, interest expense, depreciation & amortization expense and taxes paid are taken

from the profit and loss account.

 Step #3: Then, EBITDA is calculated by adding back interest expense, depreciation &

amortization expense and taxes paid to PAT.

o EBITDA = PAT + Interest + Taxes + Dep & Amort

 Step #4: Finally, the EBITDA margin is calculated by dividing the EBITDA by the sales revenue

and multiplied by 100%.

 o EBITDA Margin = EBITDA / Revenue * 100%

MARKET VALUE RATIOS

The formula for each market value ratio is as follows:

 Price/Earnings or PE Ratio = Price per share / Earnings per share (EPS)

 Earnings per Share (EPS) = Net Profit (Earnings) / total number of shares outstanding in the
market
 Book Value per Share = (Shareholder’s Equity – Preference stock) / Outstanding numbers of
shares.
 Market Value per Share = Market Capitalization / Outstanding shares in the market.
 Dividend Yield = Total dividend paid in a year / Number of shares outstanding.
 Market to Book Ratio = Price of one share / Book value of one share.

Cash flow analysis

Operating Cash Flow Ratio

The operating cash flow ratio is one of the most important cash flow ratios. Cash flowis an indication of
how money moves into and out of the company and how the company pays its bills.

Operating cash flow considers cash flows that a company accrues from operations as related to its current
debt. It measures how liquid a firm is in the short run since it shows whether or not cash flows from
operations can cover its liabilities.

Operating Cash Flows Ratio = Cash Flows From Operations/Current Liabilities

Cash Flows from Operations comes off the Statement of Cash Flows and Current Liabilities comes off
the Balance Sheet

If the Operating Cash Flow Ratio for a company is less than 1.0, the company is not generating enough
cash to pay off its short-term debt which is a serious situation. It is possible that the firm may not be able
to continue to operate.

02

Price/Cash Flow Ratio

The price to cash flow ratio is often considered a better indication of a company's value than the price to
earnings ratio. It is a really useful ratio for a company to know, particularly if the company is publicly
traded. It compares the company's share price to the cash flow the company generates on a per share
basis.
Calculate the price/cash flow ratio as follows:

Price/cash flow ratio = Share price/Operating cash flow per share

Share price is usually the closing price of the stock on a particular day and operating cash flow is taken
from the Statement of Cash Flows. Some business owners use free cash flow in the denominator instead
of operating cash flow.

It should be noted that most analysts still use price/earnings ratio in valuationanalysis.

03

Cash Flow Margin Ratio

The Cash Flow Margin ratio is an important ratio as it expresses the relationship between cash generated
from operations and sales.

The company needs cash to pay dividends, suppliers, service its debt, and invest in new capital assets, so
cash is just as important as profit to a business firm.

The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is:

Cash flow from operating cash flows/Net sales = _____percent

The numerator of the equation comes from the firm's Statement of Cash Flows. The denominator comes
from the Income Statement. The larger the percentage, the better.

04

Cash Flow from Operations/Average Total Liabilities

Cash flow from Operations/Average total liabilities is a similar ratio to the commonly-used total
debt/total assets ratio. Both measure the solvency of a company or its ability to pay its debts and keep its
head above water. The former is better, however, as it measures this ability over a period of time rather
than at a point in time since it uses average figures.

This ratio is calculated as follows:

Cash flow from Operations/Average Total Liabilities = _______percent

Cash flow from operations is taken from the Statement of Cash Flows and average total liabilities is an
average of total liabilities from several time periods of liabilities taken from balance sheets.

The higher the ratio, the better the firm's financial flexibility and its ability to pay its debts.