Ratio Analysis

Liquidity Ratios and Values

Show the ability of a company to pay current liabilities without having to borrow.

Working Capital

A large positive working capital shows company has the ability to repay its short term debts. $\text{Working Capital}=\text{Current Assets}-\text{Current Liabiltiies}$

Current Ratio

$\frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}$ Ex. 2.8 : 1 ratio For every dollar of current Liability, this company has 2.8 dollars of current Assets. (>= 2 : 1 ratio is good)

Quick Ratio

$\frac{\text{Current Assets (Only Cash, A/R, and Securities)}}{\text{Total Current Liabilities}}$ (>= 1:1 ratio is good)

Inventory Turnover Period

Indicates the time it takes for a company to sell and then replace its inventory. $\frac{\text{Ending Inventory}}{\text{Cost of Goods Sold}}\cdot 365$ If it is too high, then storage costs are high and profits are reduced. If it is too low, then sales may be lost because of the lack of merchandise. (35-45 days is good)

Accounts Receivable Turnover Period

Indicates the average time it takes a company to collect its A/R accounts $\frac{\text{Accounts Receievable}}{\text{Net Sales on Credit}}\cdot 365$ (45 days is good)

Borrowing Capacity Ratios

Equity Ratio (%)

Indicates the percentage of assets financed by the owner $\frac{\text{Owner’s Equity}}{\text{Total Assets}}\cdot 100$

Debt Ratio (%)

Indicates the percentage of assets financed through debt (loan, credit) $\frac{\text{Total Debts}}{\text{Total Assets}}\cdot 100$

IMPORTANT

A business owner favours low equity ratios and high debt ratios if the debt interest is low A lender prefers a company to have a higher equity ratio (low debt ratio indicates the ability to repay a loan)

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$\text{Equity Ratio}+\text{Debt Ratio}=100$

Profitability Analysis

Rate of Return on Net Sales

Indicates the percentage of sales that represent profit $\frac{\text{Net Income}}{\text{Net Sales}}\cdot 100$

Rate of Return on Average Owner’s Equity

Step 1

$\text{Average OE}=\frac{\text{Beginning OE + Ending OE}}{2}$

Step 2

$\text{Rate of Return on Average OE}=\frac{\text{Net Income}}{\text{Average OE}}\cdot 100$ The rate of return should be higher than the rate of return an owner could receive from other forms of investments (Stock Market, Deposits in Bank, Bonds)