Short-term Solvency or Liquidity Ratios

Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial distress in the short-run. The two most important Short-term Solvency Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid-Test Ratio.)

Current Ratio
The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are the assets that the firm expects to convert into cash in the coming year and Current Liabilities represent the liabilities which have to be paid in cash in the coming year. The appropriate value for this ratio depends on the characteristics of the firm's industry and the composition of its Current Assets. However, at a minimum, the Current Ratio should be greater than one.

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Example Problems Use the information below to calculate the Current Ratio. Current Assets: $ Current Liabilities: $ Current Ratio:
1500

1000

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Quick Ratio
The Quick Ratio recognizes that, for many firms, Inventories can be rather illiquid. If these Inventories had to be sold off in a hurry to meet an obligation the firm might have difficulty in finding a buyer and the inventory items would likely have to be sold at a substantial discount from their fair market value. This ratio attempts to measure the ability of the firm to meet its obligations relying solely on its more liquid Current Asset accounts such as Cash and Accounts Receivable. This ratio is calculated by dividing Current Assets less Inventories by Current Liabilities.

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Example Problems Use the information below to calculate the Quick Ratio. Current Assets: $ Inventory: $ Current Liabilities: $ Quick Ratio:
1500

500

1000

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Asset Management Ratios

Asset Management Ratios attempt to measure the firm's success in managing its assets to generate sales. For example, these ratios can provide insight into the success of the firm's credit policy and inventory management. These ratios are also known as Activity or Turnover Ratios.

Receivables Turnover and Days' Receivables

The Receivables Turnover and Days' Receivables Ratios assess the firm's management of its Accounts Receivables and, thus, its credit policy. In general, the higher the Receivables Turnover Ratio the better since this implies that the firm is collecting on its accounts receivables sooner. However, if the ratio is too high then the firm may be offering too large of a discount for early payment or may have too restrictive credit terms. The Receivables Turnover Ratio is calculated by dividing Sales by Accounts Receivables. (Note: since Accounts Receivables arise from Credit Sales it is more meaningful to use Credit Sales in the numerator if the data is available.)

The Days' Receivables Ratio is calculated by dividing the number of days in a year, 365, by the Receivables Turnover Ratio. Therefore, the Days' Receivables indicates how long, on average, it takes for the firm to collect on its sales to customers on credit. This ratio is also known as the Days' Sales Outstanding (DSO) or Average Collection Period (ACP).

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Example Problems Use the information below to calculate the Receivables Turnover and Days' Receivables Ratios. Sales: $ Accounts Receivable: $ Receivables Turnover: Days' Receivables:
1500

150

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Inventory Turnover and Days' Inventory

The Inventory Turnover and Days' Inventory Ratios measure the firm's management of its Inventory. In general, a higher Inventory Turnover Ratio is indicative of better performance since this indicates that the firm's inventories are being sold more quickly. However, if the ratio is too high then the firm may be losing sales to competitors due to inventory shortages. The Inventory Turnover Ratio is calculated by dividing Cost of Goods Sold by Inventory. When comparing one firms's Inventory Turnover ratio with that of another firm it is important to consider the inventory valuation methid used by the firms. Some firms use a FIFO (first-in-firstout) method, others use a LIFO (last-in-first-out) method, while still others use a weighted average method.

The Days' Inventory Ratio is calculated by dividing the number of days in a year, 365, by the Inventory Turnover Ratio. Therefore, the Days' Inventory indicates how long, on average, an inventory item sits on the shelf until it is sold.

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Example Problems Use the information below to calculate the Inventory Turnover

and Days' Inventory Ratios. Cost of Goods Sold: $ Inventory: $ Inventory Turnover: Days' Inventory:
1500

500

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Seasonal Industries Many firms, such as department stores, are in seaonal industries in which their assets, especially current assets, and sales volume vary throughout the year. This can be of particular concern when comparing the Asset Management Ratios of one firm with another firm in the same industry. This occurs because, in the calculation of each of the Asset Management Ratios, a number from the Income Statement is divided by a number from the Balance Sheet. The Income Statement reports revenues and expenses over a period of time (usually a year) whereas the Balance Sheet reports the firms assets and liabilities on a particular date. Thus, for firms in seasonal industries differences in performance may be detected when no actual difference exists simply because their Balance Sheets are published on different dates.

Fixed Assets Turnover

The Fixed Assets Turnover Ratio measures how productively the firm is managing its Fixed Assets to generate Sales. This ratio is calculated by dividing Sales by Net Fixed Assets. When comparing Fixed Assets Turnover Ratios of different firms it is important to keep in mind that the values for Net Fixed Assets reported on the firms' Balance Sheets are book values which can be very different from market values.

Total Assets Turnover

The Total Assets Turnover Ratio measures how productively the firm is managing all of its assets to generate Sales. This ratio is calculated by dividing Sales by Total Assets.

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Example Problems Use the information below to calculate the Fixed Assets Turnover and Total Assets Turnover Ratios. Sales: $ Net Fixed Assets: $ Total Assets: $ Fixed Assets Turnover: Total Assets Turnover:
1500

1000

1500

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Debt Management Ratios

Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid financial distress in the long run. These ratios are also known as Long-Term Solvency Ratios. Debt is called Financial Leverage because the use of debt can improve returns to stockholders in good years and increase their losses in bad years. Debt generally represents a fixed cost of financing to a firm. Thus, if the firm can earn more on assets which are financed with debt than the cost of servicing the debt then these additional earnings will flow through to the stockholders. Moreover, our tax law favors debt as a source of financing since interest expense is tax deductible. With the use of debt also comes the possibility of financial distress and bankruptcy.The amount of debt that a firm can utilize is dictated to a great extent by the characteristics of the firm's industry. Firms which are in industries with volatile sales and cash flows cannot utilize debt to the same extent as firms in industries with stable sales and cash flows. Thus, the optimal mix of debt for a firm involves a tradeoff between the benefits of leverage and possibility of financial distress.

Debt Ratio, Debt-Equity Ratio, and Equity Multiplier

The Debt Ratio, Debt-Equity Ratio, and Equity Multiplier are essentially three ways of looking at the same thing: the firm's use of debt to finance its assets. The Debt Ratio is calculated by dividing Total Debt by Total Assets. The Debt-Equity Ratio is calculated by dividing Total Debt by Total Owners' Equity. The Equity Multiplier is calculated by dividing Total Assets by Total Owners' Equity.

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Example Problems Use the information below to calculate the Debt Ratio, Debt-Equity Ratio, and Equity Multiplier. Total Assets: $ Total Debt: $ Total Owners' Equity: $ Debt Ratio: Debt-Equity Ratio: Equity Multiplier:
2000

1000

1000

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Profitability Ratios
Profitability Ratios attempt to measure the firm's success in generating income. These ratios reflect the combined effects of the firm's asset and debt management.

Profit Margin
The Profit Margin indicates the dollars in income that the firm earns on each dollar of sales. This ratio is calculated by dividing Net Income by Sales.

Return on Assets (ROA) and Return on Equity (ROE)

The Return on Assets Ratio indicates the dollars in income earned by the firm on its assets and the Return on Equity Ratio indicates the dollars of income earned by the firm on its shareholders' equity. It is important to remember that these ratios are based on Accounting book values and not on market values. Thus, it is not appropriate to compare these ratios with market rates of return such as the interest rate on Treasury bonds or the return earned on an investment in a stock.

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Example Problems Use the information below to calculate the Profit Margin, Return on Assets (ROA), and Return on Equity (ROE). Sales: $ Net Income: $ Total Assets: $ Total Owners' Equity: $ Profit Margin: Return on Assets: Return on Equity:
2000

500

1500

1000

% % %

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Market Value Ratios

Market Value Ratios relate an observable market value, the stock price, to book values obtained from the firm's financial statements.

Price-Earnings Ratio (P/E Ratio)

The Price-Earnings Ratio is calculated by dividing the current market price per share of the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net income by the number of shares outstanding.) The P/E Ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. (Investors who are willing to pay a high price for a dollar of current earnings obviously expect high earnings in the future.) In this manner, the P/E Ratio also indicates how expensive a particular stock is. This ratio is not meaningful, however, if the firm has very little or negative earnings.

where

Market-to-Book Ratio
The Market-to-Book Ratio relates the firm's market value per share to its book value per share. Since a firm's book value reflects historical cost accounting, this ratio indicates management's success in creating value for its stockholders. This ratio is used by "value-based investors" to help to identify undervalued stocks.

where

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Example Problems Use the information below to calculate the Price-Earnings Ratio

and Market-to-Book Ratio. Net Income: $ Total Owners' Equity: $ Stock Price: $ Number of Shares Outstanding: Price-Earnings Ratio: Earnings per Share: $ Market-to-Book Ratio: Book Value per Share: $
2000

5000

25

1000

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Ratio Equations
Short-term Solvency Ratios Current Ratio: Quick Ratio: Asset Management Ratios Receivables Turnover: Days' Receivables:

Inventory Turnover: Days' Inventory: Fixed Assets Turnover: Total Assets Turnover: Debt Management Ratios Times Interest Earned (TIE) Ratio: Debt Ratio: Debt-Equity Ratio: Equity Multiplier: Profitability Ratio Profit Margin: Return on Assets: Return on Equity: Market Value Ratios Price/Earnings Ratios: Market-toBook Ratio: Dividend Ratios Payout Ratio:

Retention Ratio: Other Equations Earnings Per Share: Book Value Per Share:

Financial Statement Analysis - Liquidity Ratios

In analyzing Financial Statements for the purpose of granting credit Ratios can be broadly classified into three categories.
Liquidity Ratios Efficiency Ratios Profitability Ratios

Liquidity Ratios:

Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the liquidity of the company as on a particular day i.e the day that the Balance Sheet was prepared. These ratios are important in measuring the ability of a company to meet both its short term and long term obligations.
FIRST LIQUIDITY RATIO

Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations. The formula: Current Ratio = Total Current Assets/ Total Current Liabilities An example from our Balance sheet:

Current Ratio = $261,050 / $176,522 Current Ratio = 1.48 The Interpretation: Lumber & Building Supply Company has $1.48 of Current Assets to meet $1.00 of its Current Liability Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Current Ratio Calculator Click here click here
SECOND LIQUIDITY RATIO

Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true 'working capital' relationship of its cash, accounts receivables, prepaids and notes receivables available to meet the company's current obligations. The formula: Quick Ratio = Total Quick Assets/ Total Current Liabilities Quick Assets = Total Current Assets (minus) Inventory An example from our Balance sheet: Quick Ratio = $261,050- $156,822 / $176,522 Quick Ratio = $104,228 / $176,522 Quick Ratio = 0.59 The Interpretation: Lumber & Building Supply Company has $0.59 cents of Quick Assets to meet $1.00 of its Current Liability Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Quick Ratio Calculator Click here click here .
THIRD LIQUIDITY RATIO

Debt to Equity Ratio: This ratio is obtained by dividing the 'Total Liability or Debt ' of a company by its 'Owners Equity a.k.a Net Worth'. The ratio measures how the company is leveraging its debt against the capital employed by its owners. If the liabilities exceed the net worth then in that case the creditors have more stake than the shareowners. The formula: Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth An example from our Balance sheet: Debt to Equity Ratio = $186,522 / $133,522

Debt to Equity Ratio = 1.40 The Interpretation: Lumber & Building Supply Company has $1.40 cents of Debt and only $1.00 in Equity to meet this obligation. Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Debt to Equity Ratio Calculator Click here click here .

Financial Statement Analysis - Efficiency Ratios

Efficiency Ratios:

Efficiency ratios are ratios that come off the the Balance Sheet and the Income Statement and therefore incorporate one dynamic statement, the income statement and one static statement , the balance sheet. These ratios are important in measuring the efficiency of a company in either turning their inventory, sales, assets, accounts receivables or payables. It also ties into the ability of a company to meet both its short term and long term obligations. This is because if they do not get paid on time how will you get paid paid on time. You may have perhaps heard the excuse 'I will pay you when I get paid' or 'My customers have not paid me!'
FIRST EFFICIENCY RATIO

DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness with which it converts its receivables into cash. This ratio is of particular importance to credit and collection associates. Best Possible DSO yields insight into delinquencies since it uses only the current portion of receivables. As a measurement, the closer the regular DSO is to the Best Possible DSO, the closer the receivables are to the optimal level. Best Possible DSO requires three pieces of information for calculation:
Current Receivables Total credit sales for the period analyzed The Number of days in the period analyzed

Formula: Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days The formula:

Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period that is being analyzed An example from our Balance sheet and Income Statement: Total Accounts Receivables (from Balance Sheet) = $97,456 Total Credit Sales (from Income Statement) = $727,116 Number of days in the period = 1 year = 360 days ( some take this number as 365 days) DSO = [ $97,456 / $727,116 ] x 360 = 48.25 days The Interpretation: Lumber & Building Supply Company takes approximately 48 days to convert its accounts receivables into cash. Compare this to their Terms of Net 30 days. This means at an average their customers take 18 days beyond terms to pay. Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Regular DSO Calculator Click here click here
SECOND EFFICIENCY RATIO

Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the rapiditity with which the company is able to move its merchandise. The formula: Inventory Turnover Ratio = Net Sales / Inventory It could also be calculated as: Inventory Turnover Ratio = Cost of Goods Sold / Inventory An example from our Balance sheet and Income Statement: Net Sales = $727,116 (from Income Statement) Total Inventory = $156,822 (from Balance sheet ) Inventory Turnover Ratio = $727,116/ $156,822 Inventory Turnover = 4.6 times The Interpretation: Lumber & Building Supply Company is able to rotate its inventory in sales 4.6 times in one fiscal year. Review the Industry Norms and Ratios for this ratio to compare their efficiency and see if they are above, below or equal to the others in the same industry. To use the Inventory Turnover Ratio Calculator Click here click here
THIRD EFFICIENCY RATIO

Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts Payables' of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much of their suppliers money does this company use in order to fund its Sales. Higher the ratio means that the

company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers.. The formula: Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100 An example from our Balance sheet and Income Statement: Accounts Payables = $152,240 (from Balance sheet ) Net Sales = $727,116 (from Income Statement) Accounts Payables to Sales Ratio = [$152,240 / $727,116] x 100 Accounts Payables to Sales Ratio = 20.9% The Interpretation: 21% of Lumber & Building Supply Company's Sales is being funded by its suppliers. Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Accounts Payables to Sales Ratio Calculator Click here click here .

Financial Statement Analysis - Profitability Ratios

Profitability Ratios:

Profitability Ratios show how successul a company is in terms of generating returns or profits on the Investment that it has made in the business. If a business is Liquid and Efficient it should also be Profitable.
FIRST PROFITIBILITY RATIO

Return on Sales or Profit Margin (%): The Profit Margin of a company determines its ability to withstand competition and adverse conditions like rising costs, falling prices or declining sales in the future. The ratio measures the percentage of profits earned per dollar of sales and thus is a measure of efficiency of the company. The formula: Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100 An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 Net Sales (from Income Statement) = $727,116 Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100 Return on Sales or Profit Margin = 0.71% The Interpretation:

Lumber & Building Supply Company makes 0.71 cents on every $1.00 of Sale Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Return on Sales or Profit Margin Calculator click here .
SECOND PROFITABILITY RATIO

Return on Assets: The Return on Assets of a company determines its ability to utitize the Assets employed in the company efficiently and effectively to earn a good return. The ratio measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency of the company in generating profits on its Assets. The formula: Return on Assets = (Net Profit / Total Assets) x 100 An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 Total Assets (from Balance sheet) = $320,044 Return on Assets = [ $5,142 / $320,044] x 100 Return on Assets = 1.60% The Interpretation: Lumber & Building Supply Company generates makes 1.60% return on the Assets that it employs in its operations. Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Return on Assets or Profit Margin Calculator click here
THIRD PROFITABILITY RATIO

Return on Equity or Net Worth: The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividents to owners and have funds for future growth of the company The formula: Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100 Net Worth or Owners Equity = Total Assets (minus) Total Liability An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 Net Worth (from Balance sheet) = $133,522 Return on Net Worth = [ $5,142 / $133,522] x 100 Return on Equity or Return on Net Worth = 3.85% The Interpretation:

Lumber & Building Supply Company generates a 3.85% percent return on the capital invested by the owners of the company. Review the Industry Norms and Ratios for this ratio to compare and see if they are above below or equal to the others in the same industry. To use the Return on Assets or Profit Margin Calculator click here

Key Business Ratios:

Industry Norms and Key Business Ratios: The following key business ratios were obtained from the public domain and may not be accurate. However, they will give you a rough idea. Key Business Ratios can be obtained from companies like D&B (Dun & Bradstreet) or RMA. Their ratios are developed and derived from the financial statements in their extensive database. They are based on activities of numerous industries, includes a combination of financial statements and business ratios to help the credit community to compare a company's financial performance to its peer group by industry size and region. For more information and an extensive list of the key business ratios please contact your local Dun & Bradstreet or RMA office.
Current Ratio Agriculture 1.31 Mining 1.19 Construction 1.44 0.98 1.31 4.74 43.00 1.74 0.77 0.48 0.00 52.00 0.00 0.39 1.33 2.52 19.00 2.58 Quick Ratio Debt to Equity Sales to Inventory DSO Profit Margin %

Manufacturing Leather/Textile/App 1.50 Chem. Petrol. Metal 1.54 Wood Related Prod 1.43 Mach-trans equipment 1.54 0.74 1.34 5.89 51.00 2.38 0.62 1.41 6.46 33.00 2.16 0.75 1.33 6.94 48.00 2.23 0.62 1.48 6.05 34.00 1.64

Trans-Communic 1.03 0.70 1.64 0.00 34.00 1.84

Wholesale Non-Durable 1.53 0.66 1.70 4.63 39.00 1.40

Durable 1.42 0.69 1.60 7.36 31.00 1.11

Retail Hardware 1.68 Gen. Merchandise 2.14 Automobiles 1.23 Apparel 1.90 Furniture 1.61 Restaurants 0.73 0.18 1.24 35.65 1.00 0.43 0.38 1.33 4.03 16.00 0.92 0.14 0.91 2.96 2.00 1.35 0.19 2.61 4.75 9.00 0.84 0.15 0.59 3.81 4.00 0.16 0.43 1.30 4.20 22.00 1.11

Financial Services 1.18 Business Services 1.36 Service Industry 1.29 0.68 0.75 3.04 15.00 0.77 0.84 1.11 0.00 42.00 1.75 0.34 0.72 0.00 1.00 1.29