Financial Ratios (Word Scrambles with Coaching)

Working capital is the difference between a company’s current assets and current liabilities. It is one indication of a company’s ability to pay its short-term obligations.

Example: If a company has $500,000 in current assets and $300,000 in current liabilities, its working capital is $200,000. This positive working capital suggests the company can pay for its short-term liabilities with its short-term assets.

The current ratio is calculated by dividing the amount of current assets by the amount of current liabilities. It is one indication of a company’s ability to pay its short-term obligations with its short-term assets.

Example: A company with $400,000 in current assets and $200,000 in current liabilities has a current ratio of 2:1. This indicates the company has twice the amount of current assets to pay its current liabilities.

Inventory turnover is the ratio of the cost of goods sold for a specified year to its average inventory during the year. It indicates how many times on average a company’s inventory was sold during the year.

Example: If a company had a cost of goods sold of $1,000,000 for the year, and its average inventory during the year was $250,000, its inventory turnover ratio is 4.

The receivables turnover ratio is net credit sales for the year divided by the average balance in accounts receivable during the year. It indicates how efficiently a company had collected its receivables.

Example: A company with $500,000 in net credit sales for the year and an average accounts receivable balance of $50,000 during the year will have a receivables turnover ratio of 10. This means it collected its receivables on average 10 times a year or every 36 days (365 days in a year divided by 10).

Days’ sales in receivables is calculated by dividing 365 days by the receivables turnover ratio. This indicates the average number of days it took to collect accounts receivable.

Example: If a company had a receivables turnover ratio of 10, the days’ sales in receivables was 36.5 days, indicating it took the company an average of 36.5 days to collect its receivables.

Inventory is excluded from the current assets when calculating the quick ratio, since inventory is not usually turned into cash quickly.

Example: In calculating the quick ratio, a company with $40,000 in cash and $60,000 receivables and $30,000 in inventory would only include the $100,000 in cash and receivables when calculating the quick ratio.

The quick ratio is also known as the acid-test ratio. It measures a company’s ability to meet its short-term obligations without relying on the sale of its inventory.

Example: A company with $50,000 in quick assets and $25,000 in current liabilities has a quick ratio of 2:1. This indicates it can pay its short-term liabilities twice without selling inventory.

Vertical analysis involves expressing each income statement amount as a percentage of total net sales. This provides insight into the relative magnitude costs, expenses, and profit. It also allows comparing the company’s margins and percentages to other companies of various sizes.

Example: If a company has net sales of $1,000,000 and cost of goods sold of $700,000, the vertical analysis would show the cost of goods sold as 70% (of total net sales) a gross profit margin of 30%. All of the percentages can be compared to a company with sales of $53,000,000.

Common-size balance sheets show all amounts as a percentage of total assets. The percentages allow for comparing the balance sheets of different-sized companies.

Example: If a company’s total assets are $500,000 and accounts receivable are $50,000, the common-size balance sheet will show the accounts receivable as 10% (of total assets).

Horizontal analysis expresses amounts as a percentage of a base year. This assists in tracking how the amounts have changed over time.

Example: If a company’s net sales were $200,000 in the base year and increased to $300,000 in the current year, horizontal analysis would show the current year sales as 150 and the base year sales as 100.

The debt to equity ratio measures the proportion of a corporation’s total liabilities compared to its stockholders’ equity. It indicates how much of the corporation’s assets are financed by debt versus equity.

Example: A company with $400,000 in liabilities and $200,000 in equity has a debt to equity ratio of 2:1, meaning it has twice as much debt as equity.

When dividing income statement amounts by balance sheet amounts, it’s logical to use an average of the related balance sheet amounts. The reason is the amounts on the balance sheet represent the amounts at one moment, whereas the income statement amounts are for 365 days. The average amount will be more representative of the period covered by the income statement.

Example: To calculate the average accounts receivable, a company uses as many accounts receivable balances as are available for the year.

Financial ratios are part of financial statement analysis, which involves evaluating the financial health and performance of a company. Comparing financial ratios to industry standards and historical data plus other information are part of financial statement analysis.

Example: A company may compare its liquidity and financial leverage ratios to those of its industry to gain insights.

The current ratio and the quick ratio are indicators of a company’s liquidity. These indicate a company’s ability to meet short-term obligations with its current assets.

Example: A current ratio of 2.5 means that the company has $2.50 in current assets for every $1 of current liabilities, indicating good short-term liquidity.

The profit margin ratio and the return on assets are indicators of a company’s profitability.

Example: Assume a company has sales of $1,000,000 with net income of $100,000 and total assets of $500,000. The company’s profit margin of 10% and its return on assets would be 20%. These ratios can be compared to the industry’s ratios and to the company’s past ratios.

A company is considered highly leveraged if it has a large amount of debt relative to its owner’s or stockholders’ equity. A highly leveraged company is considered riskier as it must meet debt obligations regardless of its financial performance.

Example: A company with $1,000,000 in debt and $200,000 in equity has a debt to equity ratio of 5:1, indicating high leverage and perhaps significant financial risk.

Vertical analysis is associated with common-size financial statements, where each line item is expressed as a percentage of a base figure, such as total assets or net sales.

Example: If a company’s net sales are $1,000,000 and its cost of goods sold is $600,000, vertical analysis would show the cost of goods sold as 60% (of net sales).

Horizontal analysis is associated with trend analysis since they compare financial data over multiple periods to identify patterns and growth rates.

Example: If a company’s revenue was $1,000,000 last year and $1,200,000 this year, horizontal analysis would show a 20% increase in revenue year-over-year.

The receivables turnover ratio is net credit sales divided by the average accounts receivable. This indicates how efficiently a company collects on its credit sales.

Example: Assume that a company had $500,000 in net credit sales in the past year and an average accounts receivable balance of $50,000 during the year. The company’s receivables turnover ratio is 10 ($500,000/$50,000). This indicates that on average it collects its receivables 10 times a year.

Accountants calculate the inventory turnover ratio by dividing the cost of goods sold during the year by the average inventory during the year. It shows how many times its inventory is sold during a year.

Example: If a company’s cost of goods sold is $400,000 and its average inventory is $100,000, the inventory turnover ratio is 4, meaning its inventory turns over (gets sold) 4 times a year.