Accounting Ratios:

 Ratio analysis helps you to make effective and realistic comparisons.

 Ratios cannot take the place of experience or replace good management, but they can make
good managers even better.
 Ratios can reveal areas that need more investigation and help you develop a future
operating strategy. Calculating ratios is a rather simple and straightforward process.
 Because ratios make data comparable by standardizing the format, they are an important
tool for measuring the progress of a business and for discovering how a business is
performing relative to competitors.
 Ratios can translate assets (such as tools and inventory) and liabilities (such as payables
and loans) into numbers expressed in a standard format.
 These numbers can reveal valuable relationships between two seemingly unrelated items.
 Ratios also allow you to make comparisons between time periods.
 Because they allow different sets of events and operating periods to become comparable,
ratios are often used to indicate how a business is performing.
 They provide critical information from which to make sound business decisions.

Ratio Types:
1. Liquidity ratios measure the ability of a business to cover expenses and otherwise meet
its current and long-term obligations. These ratios are especially important in keeping a
business alive. Not paying bills because of a cash shortage is the fastest way to go out of
business. Lending institutions are typically reluctant to loan money to a business that finds
itself in a cash flow jam, because this is often a sign of poor management.
2. Profitability ratios measure how a business is doing relative to various benchmarks. These
ratios can help you improve income by showing where you may benefit through higher
sales, greater margins, minimizing expenses, or a combination of these methods.
3. Efficiency ratios measure and help you control the operation of a business. They add
another dimension to help you increase income by assessing such important transactions
as the use of credit, control of inventory, and/or management of assets.
 Liquidity Ratio:
Current Ratio:
 The current ratio measures the business’s ability to meet short-term obligations.
 Current assets should be 2×, or 200%, of current liabilities.
 Low Ratio: If the current ratio is low, a company might not be able to pay off bills as
rapidly as it should. It might not be able to take advantage of cash discounts or other
favorable terms. It might not be able to keep its suppliers happy and receive good service.
A high inventory might indicate an accompanying high accounts-payable value and might
therefore suggest a liquidity problem.
 High Ratio: If the current ratio is high, a company has money—typically cash, government
securities, or other safe funds—that can be applied to the business.

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Turnover-of-Cash Ratio:
 The turnover-of-cash ratio measures the turnover of cash, or working capital, relative to
sales. Maintaining a positive cash flow or working-capital balance provides a way to
finance sales without having to struggle to pay for materials.
 Sales should be 4 or 5 times the amount of working capital. A high-volume/low-price
operation, such as a grocery store, might have a turnover of 1.5 times. A low-volume/ high-
price operation, such as an equipment manufacturer, might have a turnover of 5 or 6 times.
 Low Ratio: You might have funds in cash or tied up in short-term, low-yielding assets.
This means that you might support operations with less cash, or increase your operation
without increasing your liquidity risk.
 High Ratio: A high ratio is a sign of over-trading, in which too little cash is being asked
to do too much. This could make the business vulnerable to creditors.
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 − 𝒐𝒇 − 𝑪𝒂𝒔𝒉 𝑹𝒂𝒕𝒊𝒐 =
𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
 Debt-to-Equity Ratio:
 The debt-to-equity ratio measures the relationship between capital contributed by creditors
(suppliers and banks) and the owners’ equity in the business. This ratio is also referred to
as the debt-to-worth ratio or leverage.
 A debt-to-worth ratio of 1:1 is considered normal, although in some industries it may be
two or three to one.
 Low ratio: represents greater long-term financial safety and generally means that you have
greater flexibility to borrow money. An extremely low ratio might mean that the firm’s
management is too fiscally conservative. This might indicate that the company is not
reaching its full profit potential—that is, the profit potential from leverage, which is
realized by borrowing money at a lower rate of interest and obtaining a higher rate of return
on sales.
 High Ratio: If the debt-to-equity ratio is high, greater risk is being assumed by the
company and is being passed along to creditors because the business might not be able to
meet its obligations. With high leverage, your ability to obtain money from outside sources
is limited.

𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕
𝑫𝒆𝒃𝒕 − 𝒕𝒐 − 𝑬𝒒𝒖𝒊𝒕𝒚 𝑹𝒂𝒕𝒊𝒐 =
𝑬𝒒𝒖𝒊𝒕𝒚

𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕 = 𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑵𝒆𝒕 𝑾𝒐𝒓𝒕𝒉 = 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

 Profitability Ratio:
Rate of Return on Sales Ratio:
 The rate of return on sales ratio measures the profit derived from sales. It indicates how
well you have managed your selling and other operating expenses. It also indicates whether
the business is generating enough sales to cover the fixed costs and still leave an acceptable
profit.
 Many consider a 10%–12% return acceptable, but it depends on the business and/or
industry.
 Low Ratio: This might not mean much in some industries. For example, a business (such
as a grocery store) that has a high turnover of inventory, or that uses low margins to attract
customers, might show a low ratio but still be healthy.
 High Ratio: Usually, the higher the ratio, the better. There are industry standards that
provide comparative information.
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑰𝒏𝒄𝒐𝒎𝒆
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑺𝒂𝒍𝒆𝒔 𝑹𝒂𝒕𝒊𝒐 =
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

Rate of Return on Assets:

 The rate of return on assets ratio measures the income (profit) generated by the use of
business assets.
 This ratio varies a great deal, depending on the industry, the amount of fixed assets required
by the business, the amount of cash that must be available, and other factors.
 Low ratio indicates poor performance, or ineffective use of the assets by management.
 High ratio indicates good performance, or effective use of the firm’s assets by
management.
𝑰𝒏𝒄𝒐𝒎𝒆 𝑩𝒆𝒇𝒐𝒓𝒆 𝑻𝒂𝒙𝒆𝒔
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑨𝒔𝒔𝒆𝒕𝒔 =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
 Rate of Return on Investment:
 The rate of return on investment ratio measures the return on the owner’s investment (ROI).
It shows how effective owners have been in using their own resources. The ROI can be
compared against other investment options to determine if the current investment is the
best use of these resources. This ratio is also called return on equity (ROE).
 A return on investment of 15% is generally considered acceptable and is an indication of
the business’s ability to fund future growth from within. This means that a business will
not be dependent on financing its growth with long-term debt, but will be able to generate
the needed income from its own operations.
 Low Ratio: Perhaps you could have done better by investing your money elsewhere. A
low ratio could indicate inefficient management performance, or it could reflect a highly
capitalized, conservatively operated business with little long-term debt.
 High Ratio: Perhaps creditors were a source of much of the funds used in the business. Or
management is efficient, or the company is undercapitalized (has used debt instead of
personal funds).
𝑰𝒏𝒄𝒐𝒎𝒆 𝑩𝒆𝒇𝒐𝒓𝒆 𝑻𝒂𝒙𝒆𝒔
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 =
𝑵𝒆𝒕 𝑾𝒐𝒓𝒕𝒉

Efficiency Ratio:
Average Collection Period Ratio:
 The average collection period ratio measures the turnover of receivables, or the average
number of days it takes to collect cash from your credit sales.
 This depends on your collection period policy. If you invoice with balance due in 30 days,
then 30 days is the standard.
 A low ratio indicates a fast turnover—this could be the result of a stringent collection
policy or fast-paying customers. From a liquidity perspective, the shorter your collection
period, the faster you receive payment, and so the sooner you have access to the cash
represented by the receivables.
 A high ratio indicates a slow turnover—this could be the result of a number of bad
accounts, a tax collection policy, or perhaps using credit as a tool to generate sales.
 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒆𝒅 × 𝑵𝒐. 𝒐𝒇𝑫𝒂𝒚𝒔
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒐𝒍𝒍𝒆𝒄𝒕𝒊𝒐𝒏 𝑷𝒆𝒓𝒊𝒐𝒅 𝑹𝒂𝒕𝒊𝒐 =
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

Inventory Turnover Ratio:

 The inventory turnover ratio measures how fast your merchandise is moving, or how many
times your initial inventory is replaced in a year.
 This depends on the industry and, for some industries, the time of year. A toy retailer would
begin to build inventory in July and August, moving toward the Christmas season, and
(with a little luck) would substantially reduce the inventory during that period, entering the
New Year with a low inventory. Six to seven times is a rule of thumb.
 A low ratio indicates a large inventory, a never-out-of-stock situation, or perhaps some
obsolete items. It could also indicate poor liquidity, overstocking of items, or a planned
buildup in anticipation of a coming high-selling period.
 A high ratio indicates a narrow selection, maybe fast-moving merchandise, or perhaps
some lost sales due to lack of stock. It might indicate better liquidity or even superior
merchandising.
 Average inventory is beginning inventory plus ending inventory divided by 2. For the
purpose of our calculation, we used ending inventory to approximate the average.

Manufacturers’ inventory = finished goods + raw materials + in-process materials

Retailers/wholesalers’ inventory = saleable goods on hand

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅

𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

𝑫𝒂𝒚𝒔 𝒊𝒏 𝒀𝒆𝒂𝒓
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑫𝒂𝒚𝒔 𝒊𝒏 𝑰𝒏𝒗𝒆𝒕𝒐𝒓𝒚 𝑹𝒂𝒕𝒊𝒐 =
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
 Fixed Asset Turnover Ratio:
 The fixed-asset turnover ratio, which is also called the net-sales to fixed-assets ratio,
measures management’s effectiveness in generating sales from investments in fixed assets.
A capital-intensive business would have a lower ratio than a labor-intensive business
would.
 This varies and must be viewed in the context of a business’s expectations. In general, the
range is between 1 and 3 times.
 Low Ratio: The assets might not be fully employed, or too many assets might be chasing
too few sales.
 High Ratio: In general, the higher the ratio, the smaller the investment required to generate
sales. This could lead to greater profitability.
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔