Financial Ratio definitions

Liquidity Ratios

Current Ratio = Current Assets ÷ Current Liabilities

The current ratio indicates liquidity by comparing current assets to current liabilities. Current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due with one year.

In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lowers than the industry average could indicate a lack of liquidity.

Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) ÷ Current Liabilities

The quick ratio also measures liquidity. It compares the cash plus cash equivalents and accounts receivable to current liabilities. The primary difference between the current ratio and the quick ratio is that the quick ratio does not include inventory and prepaid expenses. Consequently, a business' quick ratio will be lower than its current ratio.

Sales / Receivables = Net Sales ÷ Trade Receivables

The sales to receivables ratio measures the number of times trade receivables turn over in a year. The higher the turn over rate, the shorter the period that credit sales are turning into cash. If the ratio is significantly lower than the industry average, it may indicate and abnormally high level of slow paying accounts receivables. By dividing the number of days in a year (365), by the sales/receivables ratio, you can determine the average number of days that receivables are outstanding.

Cost of Sales / Inventory

The cost of sales to inventory ratio measures the number of times inventory turns during a given period of time (usually a year). A high ratio relative to the industry indicates that the inventory is turning over in a relatively shorter period. The reasons could be superior inventory management or conversely, inadequate inventory levels. If the ratio is significantly different than the industry average, it is important to determine why. Because this ratio compares only one day's inventory (i.e. the date of the balance sheet) to the costs of sales, seasonal fluctuations are not taken into account.

Cost of Sales / Payables

The cost of sales to payable ratio measures the number of times trade payables turn during a given period of time (usually a year). The higher the payables turnover rate, the shorter the time from purchase to payment. This number can also be divided into the number of days in a year (365), to determine the average number of days that trade payables are outstanding. Slow turnover can indicate cash shortages or extended credit terms. Too short of a turnover can be a symptom of an overanxious controller. Extending the days may provide additional cash for operations.

Sales / Working Capital

The sales to working capital ratio measures the number of times that working capital (current assets minus current liabilities) turns over. Relative to the industry average, the higher the ratio, the lower the margin of safety of safety for creditors. A materially low ratio may indicate an inefficient use of working capital or the existence of redundant assets.

Coverage Ratios

Interest Coverage Ratio = Earnings before Interest and Taxes ÷ Interest Expense

The interest coverage ratio measures the ability to meet annual interest payments. A high interest coverage ratio may indicate that the firm has the capacity to increase debt. Conversely, if the ratio is too high (relative to the industry), that may be an indication that the business is undercapitalized.

Principal Coverage Ratio = (Net Income + Non-Cash Expenses) ÷ Current Portion of Long-Term Debt

The principal coverage ratio measures the ability of cash flows to meet the current portion of long-term debt. The higher the ratio, the better the coverage. The ratio is also a good indicator of the business's ability to take on more debt. It is especially helpful when determining a proper weighed average cost of capital (WACC) to apply to an earning or cash flow stream.

Leverage Ratios

Net Fixed Assets / Net Tangible Worth

The net fixed assets to net tangible worth ratio measures the amount of net worth that has been invested in tangible fixed assets. The higher the ratio, the lower the risk to equity holders (the higher the tangible assets “coverage”, the lower the risk). The lower the perceived risk, the lower the required rate of return. Net fixed assets include vehicles, furniture, fixtures, equipment, and real property. Tangible net worth is stockholder's equity less any tangible assets (goodwill, trademarks, copyrights, etc.).

Total Liabilities / Net Worth = Total Liabilities ÷ Tangible Net Worth

The total liabilities to net worth ratio expresses the relationship between capital contributed by creditors and the contributed by equity holders. It expresses the degree of protection provided by the owners to the creditors. The higher the ratio, the greater the risk assumed by creditors. Conversely, a low ratio indicates a more stable financial position with possible collateral opportunities for outside financing.

Operating Ratios

Profits Before Taxes / Tangible Net Worth

The profits before taxes to tangible net worth ratio measures the rate of return on invest capital. When used in conjunction with other operating ratios, it is a good indicator of management's efficiency in the use of the capital.

Profits Before Taxes / Total Assets

The profits before taxes to total assets ratio expresses the pre-tax return on total assets. It measures the effectiveness of the management in employing resources. The ratio can easily be affected by high depreciation, excessive amounts of intangible assets, or unusual income or expenses. The ratio is probably more effectively used in comparison to the industry and/or in conjunction with other ratios.

Sales / Net Fixed Assets

The sales to the net fixed assets ratio is another measure of the efficiency with which management utilizes resources. Specifically, the ratio measures the efficiency of the utilization of fixed assets. When comparing the ratio to the industry, it is important to note the disparity of the average accumulated depreciation rate for the industry and for the subject company. If the accumulated depreciation rates are significantly different, the sales to net fixed assets ratio will also materially differ.

Sales / Total Assets

The sales to total assets ratio is a general measure of the ability to generate sales in relation to total assets. It should be used only to compare firms within a specific industry group.

Other Ratios

Earnings Before Income Taxes / Total Sales

The earnings before income taxes to total sales ratio measures profitability on total sales. In general, the higher the ratio, the stronger the business.

Officers' Compensation / Sales

The officers' compensation to sales ratio is extremely important when valuing a closely held business. Because of income tax consequences, it is common for owners to expense out profits as owners' compensation. Therefore, many times the net income to sales percentages will be meaningless.