FINANCIAL RATIOS

LIQUIDITY RATIOS

1. Current Ratio = Current Assets / Current Liabilities 

Can the company pay its bills comfortably?  A ratio greater than one shows liquidity.  It shows that there is leeway in the current assets available to pay for current liabilities. 

CAPITALICATION RATIOS 

2. Financial Leverage = (Total Liabilities + Owner’s Equity) / OE 

When a company assumes a lager proportion of debt than the amount invested by its owners, it is said to be leveraged.  In a profitable company, by using a higher level of debt, the return is much higher because a smaller amount appears in the denominator of the ratio.   The “same” amount of earnings is divided by a smaller equity base.   Ratios of greater than 2 show an extensive use of debt.  

3. Long-term Debt to Capital = Long-term Debt / (Liabilities + OE) 

Because debt payments are fixed obligations that must be paid while dividends to investors are not, the level of debt is a very important measure of a company’s riskiness.  A ratio of greater than 50 percent shows a high level of debt.  

ACTIVITY RATIOS

4. Asset Turnover per Period = Sales / Total Assets 

This ratio tells how actively the firm uses all of its assets.   

5. Inventory Turns per Period = Cost of Goods Sold / Average Inventory Held During the Period 

( A simple way to calculate “Average Inventory” is by adding the beginning and ending inventory balances, then dividing by two.) 

6. Days sales in Inventory = Ending Inventory / (Cost of Goods Sold / 365)  

These two activity ratios show how actively a company’s inventory is being deployed.  Is inventory sitting around collecting dust or is it being sold as soon as it hits the shelf?  In a high-turnover business, like the grocery trade, there are many turns of inventory during a year and only a few days of inventory on hand.  Most grocery items are perishable and purchased frequently.   

PROFITABILITY RATIOS 

7. Return on Sales (ROS) = Net Income /Sales  

“Return” ratios calculate the return on just about any part of the balance sheet and income statement.  Another common one is the return on assets (ROA) 

8. Return on Equity (ROE) = Net Income / Owners’ Equity 

The mix of debt and equity can dramatically affect the ratios.  If a company has a high level of debt and a small amount of equity, the return on equity (ROE) can be tremendously affected.  That is called financial leverage. 

THE DU PONT CHART

The chart shows how several of the most important financial statement ratios are related to one another by displaying their components. The ratios share the same inputs.  For example, when Total Assets is reduced, both the Asset Turnover and Return on Assets ratios increase because Total Assets are included in the calculation of both of those ratios as a denominator.   Conversely, a reduction of Total Assets (equal to total liabilities and owners’ equity) increases Financial Leverage as it is used in the ratio’s numerator.