Financial Ratios Flashcards
Liqudity/Current Ratio - Formula
Current Ratio = Current Assets / Current Liabilities
The higher the current ratio, the more capable the business is of meeting its short-term obligations.
It’s generally accepted that a ratio of 2:1 indicates a sound financial position for a firm. That is, the firm should have double the amount of assets to cover its liabilities.
Liquidity/Current Ratio - Definition
Liquidity is the extent to which the business can meet its financial commitments in the short term, which usually refers to a period of less than 12 months. To assess a business’s liquidity, its managers must assess whether the business can pay its debts when they are due. Current assets and current liabilities determine the liquidity or short-term financial stability of a business.
The ratio to show liquidity (short-term financial stability), is calculated from balance sheet figures.
The current ratio measures a business’s ability to pay back its current liabilities with its current assets.
Gearing (solvency) - Definition
Gearing is the proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business. Gearing ratios determine the firm’s solvency.
Solvency is the extent to which the business can meet its financial commitments in the longer term (more than 12 months).
Gearing (debt to equity ratio) - Formula
Debt to equity ratio = Total liabilities / Total Equity
A gearing ratio of 1:1 indicates a sound financial position for a business to be in (ie; the business has $1 of debt for every $1 of equity).
Gearing (debt to equity ratio) - Definition
The debt-to-equity ratio shows the extent to which the firm is relying on debt or outside sources to finance the business.
This ratio is calculated from balance sheet figures.
This ratio is an important management control aspect because the debt and equity relationship must be carefully balanced. A ratio of greater than 1 means that the business has less equity than debt. A ratio of between 0 and 1 means that the business has more equity than debt.
The higher the ratio, the less solvent the firm. That is, the higher the ratio of debt to equity, the higher the risk. As a general rule, a business would not want to have more debt than equity in the business as it would be vulnerable to interest rate rises.
Profitability - Definition
Profitability is the earning performance of the business and indicates its capacity to use its resources to maximise profits.
The income/revenue statement is used to measure the profitability or earning capacity of the firm. The three probability ratios are;
- Gross profit ratio
- Net Profit ratio
- Return on Equity (ROE) ratio
Gross Profit Ratio - Formula
Gross Profit ratio = Gross profit / Sales
The ratio is expressed as a %
Gross profit is the difference between sales revenue and the direct cost of goods sold (COGS). Gross profit is calculated as sales. This ratio shows the percentage of each dollar of sales that is gross profit.
It’s important to note that gross profit is only calculated for businesses that sell stock, not service businesses.
Net Profit Ratio - Formula
Net profit ratio = Net profit / Sales
The ratio is expressed as a %.
Net profit is the difference between the gross profit and expenses. Net profit is calculated as gross profit - expenses.
It shows the amount of sales revenue that results in a net profit.
Return on Equity Ratio (ROE) - Formula
Return on equity ratio = Net Profit / Total equity
The ratio is expressed as a percentage (%)
Uses the income/revenue statement and balance sheet.
The return on equity ratio indicates how much return the owner has received for their investment into the business.
Efficiency - Defintition
Efficiency is the ability of the firm to use its resources effectively to ensure financial stability and profitability of the business. Efficiency relates to the effectiveness of management in directing and maintaining the goals and objectives of the firm. The more efficient the firm, the greater its profits and financial stability.
Expense Ratio - Formula
Expense Ratio - Total Expenses / Sales
The ratio is expressed as a %
The expense ratio compares total expenses with sales. It uses the income/revenue statement. The ratio indicates the amount of sales that are allocated to individual expenses, such as selling, administration, cost of goods sold and financial expenses. The expense ratio indicates the day-to-day efficiency of the business.
Accounts recievable turnover ratio - Formula
Accounts recievable turnover ratio = Sales / Accounts Recievable
The ratio is expressed in days
The accounts receivable turnover ratio measures the effectiveness of a firm’s credit policy and how efficiently it collects its debts. It uses the income/revenue statement.
It measures how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts. By dividing the ratio into 365, businesses can determine the average length of time it takes to convert the balance into cash.
