Financial ratios allow us to look at profitability, use of assets, inventories,
Financial ratios allow us to look at profitability, use of assets, inventories, and other assets, liabilities, and costs associated with the finances of the business. We can also use them to learn how quickly people pay their bills, how long it takes the company to recover its costs for new equipment, how much cash the company has relative to its debt, and its return (profit) on every dollar the company invests. Financial ratios also enable a company to compare itself to other firms in the same industry and answer questions like “Are the other dog biscuit companies doing about the same as ours?”
Sometimes it’s not enough to say that a company is in good or bad financial health, especially if you’re trying to compare that company with another one. To make comparisons easier, it helps to assign numbers to “health.” The following video explains how that can be done.
Logical relationships exist between certain accounts or items in a company’s financial statements. These accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form called ratios. These ratios include the following:
| Ratio | Use | Components |
| Liquidity ratio | indicate a company’s short-term debt-paying ability | current (or working capital) ratio; acid-test (quick) ratio; cash flow liquidity ratio; accounts receivable turnover; number of day’s sales in accounts receivable; inventory turnover; and total assets turnover |
| Equity (long-term solvency) ratio | show the relationship between debt and equity financing in a company | equity (or stockholders’ equity) ratio; and stockholders’ equity to debt ratio |
| Profitability test | an important measure of a company’s operating success | rate of return on operating assets; net income to net sales; net income to average common stockholders’ equity; cash flow margin; earnings per share of common stock; times interest earned ratio; and times preferred dividends earned ratio |
| Market test | help investors and potential investors assess the relative merits of the various stocks in the marketplace | earnings yield on common stock; price-earnings ratio; dividend yield on common stock; payout ratio on common stock; dividend yield on preferred stock; and cash flow per share of common stock |
Many of these ratios are beyond the scope of this course; however, we will examine the ones in bold, above, which are key to evaluating any business.
Current (or Working Capital) Ratio
Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current assets, and thus shows the strength of the company’s working capital position.
You can compute the current ratio by dividing current assets by current liabilities, as follows:
The ratio is usually stated as a numb