Financial Ratios

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Financial Ratios Based on the Balance Sheet

Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely on current asset and current liability amounts appearing on a company's balance sheet:

 Financial Ratio How to Calculate It What It Tells You Working Capital === Current Assets – Current Liabilities \$89,000 – \$61,000 \$28,000 An indicator of whether the company will be able to meet its current obligations (pay its bills, meet its payroll, make a loan payment, etc.) If a company has current assets exactly equal to current liabilities, it has no working capital. The greater the amount of working capital the more likely it will be able to make its payments on time. Current Ratio === Current Assets ÷ Current Liabilities \$89,000 ÷ \$61,000 1.46 This tells you the relationship of current assets to current liabilities. A ratio of 3:1 is better than 2:1. A 1:1 ratio means there is no working capital. Quick Ratio (Acid Test Ratio) ==== [(Cash + Temp. Investments + Accounts Receivable) ÷ Current Liabilities] : 1 [(\$2,100 + \$100 + \$10,000 + \$40,500) ÷ \$61,000] : 1 [\$52,700 ÷ \$61,000] : 1 0.86 : 1 This ratio is similar to the current ratio except that Inventory, Supplies, and Prepaid Expenses are excluded. This indicates the relationship between the amount of assets that can quickly be turned into cash versus the amount of current liabilities.

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to income statement amounts. To illustrate these financial ratios we will use the following income statement information:

 Example Corporation Income Statement For the year ended December 31, 2011
Sales (all on credit) \$500,000
Cost of Goods Sold   380,000
Gross Profit   120,000

Operating Expenses
Selling Expenses 35,000
Total Operating Expenses    80,000

Operating Income 40,000
Interest Expense    12,000

Income before Taxes 28,000
Income Tax Expense     5,000

Net Income after Taxes \$ 23,000

 Financial Ratio How to Calculate It What It Tells You Accounts Receivable Turnover === Net Credit Sales for the Year ÷ Average Accounts Receivable for the Year \$500,000 ÷ \$42,000 (a computed average) 11.90 The number of times per year that the accounts receivables turn over. Keep in mind that the result is an average, since credit sales and accounts receivable are likely to fluctuate during the year. It is important to use the average balance of accounts receivable during the year. Days' Sales in Accounts Receivable === 365 days in Year ÷ Accounts Receivable Turnover in Year 365 days ÷ 11.90 30.67 days The average number of days that it took to collect the average amount of accounts receivable during the year. This statistic is only as good as the Accounts Receivable Turnover figure. Inventory Turnover === Cost of Goods Sold for the Year ÷ Average Inventory for the Year \$380,000 ÷ \$30,000 (a computed average) 12.67 The number of times per year that Inventory turns over. Keep in mind that the result is an average, since sales and inventory levels are likely to fluctuate during the year. Since inventory is at cost (not sales value), it is important to use the Cost of Goods Sold. Also be sure to use the average balance of inventory during the year. Days' Sales in Inventory === 365 days in Year ÷ Inventory Turnover in Year 365 days ÷ 12.67 28.81 The average number of days that it took to sell the average inventory during the year. This statistic is only as good as the Inventory Turnover figure.

The next financial ratio involves the relationship between two amounts from the balance sheet: total liabilities and total stockholders' equity:

 Financial Ratio How to Calculate It What It Tells You Debt to Equity === (Total liabilities ÷ Total Stockholders' Equity) : 1 ( \$481,000 ÷ \$289,000) : 1 1.66 : 1 The proportion of a company's assets supplied by the company's creditors versus the amount supplied the owner or stockholders. In this example the creditors have supplied \$1.66 for each \$1.00 supplied by the stockholders.

 Calculate 24 Financial Ratios using our Business FormsWhether you are a business person or student of business, our Master Set of 87 Business Forms will assist you in preparing financial ratios, financial statements, break-even calculations, depreciation, standard cost variances, and much, much more. Click here to learn more

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