Ratios Flashcards
Current Ratio
Current assets / current liabilities
The current ratio (also known as working capital ratio) is used to measure liquidity by comparing the proportion of current assets to current liabilities. The purpose is to determine whether short-term assets (cash, cash equivalents, marketable securities, receivables, inventory, and so on) are sufficient to cover short-term liabilities (bank overdraft, notes payable, current portion of term debt, payables, accrued expenses, taxes, and so on).
In theory, the higher the current ratio, the better. However, this is not necessarily always the case, as it could indicate mismanagement of working capital. Conversely, a low current ratio is not necessarily bad. A company that operates on a cash basis with limited inventory, such as a restaurant, can do just fine with a nominal current ratio. So typical values for the current ratio can vary by organization and industry. Organizations in cyclical industries may strive for a higher current ratio to remain solvent during economic downturns.
Quick Ratio
(Current assets – prepaid expenses – inventory) / current liabilities
The quick ratio (also known as the acid test ratio) is a liquidity measure that refines the current ratio by comparing only the most liquid current assets (cash, accounts receivable, notes receivable, and so on) with current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to liquidate. Therefore, a higher ratio means a more liquid current position. As with the current ratio, however, a higher quick ratio is not always optimal. A high ratio might indicate that the organization maintains excessive amounts of liquid assets.
Receivables turnover
Credit sales / average accounts receivable
The receivables turnover ratio measures how quickly accounts receivable are collected. When it is not possible to use the average accounts receivable, ending accounts receivable for that period will be used instead. In general, the higher the receivables turnover rate, the more efficiently receivables are collected. Greater efficiency both reduces the risk of receivables becoming uncollectable (that is, bad debts) and converts this source of working capital into a more liquid asset, cash. A high receivables turnover is not always optimal. A high ratio may indicate that the organization has an excessively tight credit-granting policy, which has resulted in fewer sales.
Average collection period
Average accounts receivable / (credit sales / 365)
The average collection period is derived from the receivables turnover ratio and measures the average number of days that credit sales remain in accounts receivable before they are collected. When it is not possible to use the average accounts receivable, ending accounts receivable for that period will be used instead. It is often used to assess the efficiency of receivables collections and the effectiveness of collection policies. This ratio can also be used to assess the risk that overdue receivables will become uncollectable (that is, bad debts).
Inventory turnover
Cost of goods sold / average inventory
the inventory turnover ratio measures how quickly inventory is sold. When it is not possible to use the average inventory, ending inventory for that period will be used instead. Generally speaking, the higher the inventory turnover rate, the more efficiently inventory is being managed. Higher turnover is of benefit because it reduces the risk of inventory obsolescence and converts this source of working capital more quickly into a liquid asset, cash. A high inventory turnover is not always optimal. A high ratio may indicate that the organization has a shortage of inventory on hand for sale, which has resulted in fewer sales.
Inventory period
Average inventory / (cost of goods sold / 365)
the inventory period measures the number of days that goods remain in inventory before they are sold. When it is not possible to use the average inventory, ending inventory for that period will be used instead. It is often used to assess how efficiently inventory is managed. In this way, it can also be used to assess the risk of inventory obsolescence.
Gross margin percentage
(Sales – cost of goods sold) / sales
The gross profit margin percentage measures the percentage of each sales dollar that remains after recovering the cost of goods sold.
Profit margin
Net income / sales
The profit margin ratio measures overall profitability after all expenses, including cost of goods sold, operating and financing expenses, and taxes. It measures the so-called bottom line and is frequently mentioned when discussing a company’s profitability.
Return on assets (ROA)
Net income / average total assets
Return on assets (ROA) measures how effectively assets are used to generate profits.
Return on equity (ROE)
Net income / average equity
Return on equity (ROE) measures the profits earned for each dollar invested in equity.
Debt ratio
Total liabilities / total assets
The debt ratio compares a company’s total debt to its total assets. It is used to assess the amount of leverage being used to finance assets. A low debt ratio means that the organization is less dependent on leverage. A higher ratio means that the organization is more leveraged and is considered to be more financially risky.
Debt - to - equity
Total liabilities / equity
The debt-to-equity ratio compares total liabilities to total equity. It is a measurement of how much suppliers, lenders, and other creditors have committed to the organization versus what owners have committed.
Similar to the debt ratio, the debt-to-equity ratio measures the degree of leverage. Similar to the debt ratio, a lower percentage indicates less leverage and a stronger equity position.
Debt service coverage
Net operating income / (principal + interest payments)
The debt service coverage looks at net income as a multiple of the debt payments due within a year. This is a measure of how much cash, after expenses are covered, is available to pay debt.
Times-interest-earned ratio
EBIT / interest expense
The times-interest-earned ratio is used to measure the ability to pay interest expenses from income. The lower the ratio, the more income is burdened by debt expense.
Asset turnover
Sales / average total assets
Asset turnover ratios indicate how efficiently assets are utilized. Because of this, they are sometimes also referred to as efficiency ratios or asset utilization ratios.
