Financial Ratios:

LIQUIDITY RATIOS
Liquidity ratios measure your company's ability to cover its expenses. The two most common
liquidity ratios are the current ratio and the quick ratio. Both are based on balance sheet
items.

CURRENT RATIOS:
Current Ratio=Current liabilities / Current assets

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations
or those due within one year. It tells investors and analysts how a company can maximize the
current assets on its balance sheet to satisfy its current debt and other payables.

Current assets listed on a company's balance sheet include cash, accounts receivable, inventory and
other assets that are expected to be liquidated or turned into cash in less than one year. Current
liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt.

Interpreting the Current Ratio

A ratio under 1 indicates that the company’s debts due in a year or less are greater than its
assets (cash or other short-term assets expected to be converted to cash within a year or less.)

On the other hand, in theory, the higher the current ratio, the more capable a company is of
paying its obligations because it has a larger proportion of short-term asset value relative to
the value of its short-term liabilities. However, while a high ratio, say over 3, could indicate
the company can cover its current liabilities three times, it may indicate that it's not using its
current assets efficiently, is not securing financing very well, or is not managing its working
capital.

QUICK RATIO

The Quick Ratio is also called the "acid test" ratio. That's because the quick ratio looks only
at a company's most liquid assets and compares them to current liabilities. The quick ratio
tests whether a business can meet its obligations even if adverse conditions occur.

Quick Ratio = (Current Assets − Inventory)/Current Liabilities

The numerator of liquid assets should include the assets that can be easily converted to cash in the
short-term (within 90 days or so) without compromising on their price. Inventory is not included in
the quick ratio. Similarly, only accounts receivable that can be collected within about 90 days should
be considered.
OPERATING RATIOS
There are many types of ratios that you can use to measure the efficiency of your company's
operations. In this section we will look at four that are widely used. There may be others that
are common to your industry, or that you will want to create for a specific purpose within
your company.

The four ratios we will look at are:

 Inventory Turnover Ratio

 Sales to Receivables Ratio

 Days' Receivables Ratio

 Return on Assets

INVENTORY TURNOVER

The inventory turnover ratio measures the number of times inventory "turned over" or
was converted into sales during a time period. It is also known as the cost-of-sales to
inventory ratio. It is a good indication of purchasing and production efficiency.

The data used to calculate this ratio come from both the company's income statement and
balance sheet. Here is the formula:

Inventory Ratio = Cost of Goods Sold/Inventory

 The higher the inventory turnover, the better since a high inventory turnover
typically means a company is selling goods very quickly and that demand for their
product exists.
 Low inventory turnover, on the other hand, would likely indicate weaker sales and
declining demand for a company’s products.
 Inventory turnover provides insight as to whether a company is managing its
stock properly. The company may have overestimated demand for their products and
purchased too many goods as shown by low turnover. Conversely, if inventory
turnover is very high, they might not be buying enough inventory and may be missing
out on sales opportunities.
 Inventory turnover also shows whether a company’s sales and purchasing
departments are in sync. Ideally, inventory should match sales. It can be quite costly
for companies to hold onto inventory that isn’t selling, which is why inventory
turnover can be an important indicator of sales effectiveness but also for managing
operating costs. Alternatively, for a given amount of sales, using less inventory to do
so will improve inventory turnover.
SALES-TO-RECEIVABLES RATIO

The sales-to-receivables ratio measures the number of times accounts receivables turned over
during the period. The higher the turnover of receivables, the shorter the time between making
sales and collecting cash. The ratio is based on NET sales and NET receivables. (A reminder:
net sales equals sales less any allowances for returns or discounts. Net receivables equal
accounts receivable less any adjustments for bad debts.)

This ratio also uses information from both the balance sheet and the income statement. It is
calculated as follows:

Sales-to-Receivables Ratio = Net Sales/Net Receivables

 The accounts receivable turnover ratio is an accounting measure used to quantify a

company's effectiveness in collecting its receivables or money owed by clients.
 A high receivables turnover ratio can indicate that a company’s collection of accounts
receivable is efficient and that the company has a high proportion of quality
customers that pay their debts quickly.
 A low receivables turnover ratio might be due to a company having a poor collection
process, bad credit policies, or customers that are not financially viable or
creditworthy.
 A company’s receivables turnover ratio should be monitored and tracked to determine
if a trend or pattern is developing over time.

DAYS' RECEIVABLES RATIO

The days' receivables ratio measures how long accounts receivable are outstanding.
Business owners will want as low a days' receivables ratio as possible. After all, you want
to use your cash to build your company, not to finance your customers. Also, the
likelihood of non-payment typically increases as time passes.

It is computed using the sales/receivables ratio. Here is the formula:

Days' Receivables Ratio = 365/Sales Receivables Ratio

RETURN ON ASSETS

The return on assets ratio measures the relationship between profits your company generated
and assets that were used to generate those profits. Return on assets is one of the most
common ratios for business comparisons. It tells business owners whether they are earning a
worthwhile return from the wealth tied up in their companies. In addition, a low ratio in
comparison to other companies may indicate that your competitors have found ways to
operate more efficiently.

Return on Assets = Net Income Before Taxes/Total Assets X 100

SOLVENCY RATIOS
Solvency ratios measure the stability of a company and its ability to repay debt. These ratios
are of particular interest to bank loan officers. They should be of interest to you, too, since
solvency ratios give a strong indication of the financial health and viability of your business.

We will look at the following solvency ratios:

 Debt-to-worth ratio

 Working capital

 Net sales to working capital

 Z-Score

DEBT-TO-WORTH RATIO

The debt-to-worth ratio (or leverage ratio) is a measure of how dependent a company is
on debt financing as compared to owner's equity. It shows how much of a business is
owned and how much is owed.

The debt-to-worth ratio is computed as follows:

Debt-to-Worth Ratio = Total Liabilities/Net Worth

(A reminder: Net Worth = Total Assets Minus Total Liabilities.)

 The debt-to-equity (D/E) ratio compares a company’s total liabilities to its

shareholder equity and can be used to evaluate how much leverage a company is
using.
 Higher leverage ratios tend to indicate a company or stock with higher risk to
shareholders.
 However, the D/E ratio is difficult to compare across industry groups where ideal
amounts of debt will vary.
 Investors will often modify the D/E ratio to focus on long-term debt only because the
risk of long-term liabilities are different than for short-term debt and payables.
WORKING CAPITAL

Working capital is a measure of cash flow, and not a real ratio. It represents the amount of
capital invested in resources that are subject to relatively rapid turnover (such as cash,
accounts receivable and inventories) less the amount provided by short-term creditors.
Working capital should always be a positive number. Lenders use it to evaluate a
company's ability to weather hard times. Loan agreements often specify that the borrower
must maintain a specified level of working capital.

Working capital is computed as follows:

Working Capital = Total Current Assets − Total Current Liabilities

NET SALES TO WORKING CAPITAL(Working Capital Turnover)

The relationship between net sales and working capital is a measurement of the efficiency in
the way working capital is being used by the business. It shows how working capital is
supporting sales.

It is computed as follows:

Net Sales to Working Capital Ratio = Net Annual Sales/Net Average Working Capital

A high turnover ratio shows that management is being very efficient in using a company’s short-term
assets and liabilities for supporting sales (i.e., it is generating a higher dollar amount of sales for
every dollar of the working capital used). In contrast, a low ratio may indicate that a business is
investing in too many accounts receivable and inventory to support its sales, which could lead to an
excessive amount of bad debts or obsolete inventory.

Reference:

https://edwardlowe.org/how-to-analyze-your-business-using-financial-ratios-
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