COMMONLY USED RATIOS
Liquidity is defined as having enough cash (or near-cash assets) to pay your bills when they come due. The liquidity ratios compare the assets that will be converted into cash soon (the numerator) to the bills that will be coming due soon (the denominator).
You always want to compare the liquidity ratios to the industry average, but two other factors should be
considered as well:
; The predictability (or stability) of the company’s sales. If you know how much money will be received
each month, you don’t need to keep as much cash on hand as you would otherwise. Companies with
highly unpredictable sales are always in danger of experiencing a sudden shortfall in sales, so they
need to keep more cash and liquid assets on hand.
; The company’s access to bank lines of credit or the credit markets. You don’t need to keep as much
money on hand if you can just pick up the phone, call the bank, and have money deposited into your
1. Current Ratio -- The current ratio is the most commonly used measure of the liquidity of a company.
It is simply a common sense measure. The numerator is the value of assets that should be converted
into cash within the next year. The denominator is the amount of bills coming due within the next
Current AssetsCurrent Ratio = Current Liabilities
2. Quick Ratio (or Acid Test Ratio) -- The quick ratio is a more restrictive measure than the current
ratio. The numerator consists of the most liquid current assets. It assumes a worst-case scenario in
which inventory cannot be sold.
The average for all manufacturing companies is about one (1.0). This average also varies a great deal
from one industry to another.
Cash + Mkt. Securities + Acc. ReceivableQuick Ratio = Current Liabilities
A commonly used variation of the ratio is:
Current Assets - InventoryQuick Ratio = Current Liabilities
This is the version that you usually see in a standard finance textbook. But notice that this variation
may include some non-liquid assets in the numerator however, such as prepaid expenses (like
insurance premiums). This is the measurement that is actually used in practice most frequently,
although the first form is theoretically superior.
II. TURNOVER (or EFFICIENCY)
Turnover ratios measure the management’s efficiency and effectiveness in managing the firm’s assets. In
general, sales (or a measure of sales, like cost of goods sold) will be in the numerator. You would like for the value of the turnover ratios to be quite high (with the exception of the average collection period).
3. Inventory Turnover -- Indicates the number of times a year that the firm’s inventory has been
replaced. A low ratio may indicate that the firm has some obsolete inventory, or that possibly, the
firm is simply overstocked on inventory. If the inventory turnover is 4 times per year, the company is
replacing its inventory approximately every 3 months; if its inventory turnover is 12 times per year, it
is replacing its inventory approximately every 30 days (or 1 month).
The most commonly used form of the ratio is:
SalesInventory Turnover = Inventory
A theoretically-superior variation of the formula is:
Cost of Goods SoldInventory Turnover = Average of last 4 quarters' Inventory
This form of the ratio is better for two reasons:
Inventory (in the ; Why substitute “Cost of Goods Sold” for “Sales” in the numerator?
denominator) is shown on the company’s books at cost; we would like to use a measure of cost
in the numerator as well (i.e., cost of goods sold) in order to get a fairer comparison.
; Why substitute “Average Inventory” for “Inventory” in the denominator? The numerator is
measured over a period of time, like a year. The denominator should show the average amount
of inventory that was available for sale during this period. For example, assume that sales
increased rapidly during the year and that inventory increased dramatically as well. We would
not want to use year-ending inventory in the denominator, as it does not accurately depict the
amount of inventory that was available for sale.
4. Accounts Receivable Turnover -- Indicates how quickly the company collects its accounts
receivable: the higher the turnover, the more quickly it collects its receivables.
SalesAccounts Receivable Turnover = Accounts Receivable
Notice that the formula assumes that all sales are on credit (and therefore go through accounts
receivable). It would be better to use credit sales in the numerator, if the value of credit sales is
available. But, if you compare the ratio to an industry average, just make sure that you are using
the same formula as your source for the industry average. You don’t want to use credit sales in the
numerator if the industry average is calculated with total sales in the numerator.
5. Average Collection Period – Technically, this is not a turnover ratio: it is the accounts receivable
turnover divided into 365 days. It is an alternate measure of how quickly accounts receivable are
being collected. The ratio calculates how long (in days) that it takes the firm to collect its receivables.
(Use credit sales if available, since only credit sales go through the accounts receivable account.)
Accounts ReceivableAverage Collection Period = Sales365
If the A/R turnover is lower than the industry average (and the average collection period is higher
than the industry average), this just means that the company is collecting its receivables slower than
other firms in the industry. However, it is quite possible that the company’s credit terms may give its
customers longer to pay than its competitors. So, rather than the industry average, it is better to
compare the company’s average collection period to the terms that they sell on, if the credit terms are
6. Total Asset Turnover -- The purpose of investing in assets is to generate sales: the higher the sales
per dollar invested in total assets, the better. This ratio measures how efficiently the management is
achieving its goal.
SalesTotal Asset Turnover = Total Assets
Major fault of the ratio: Total assets are made up of current assets and fixed assets. If the
company’s fixed assets are old (and therefore almost fully depreciated), the value of net fixed assets
on the balance sheet will be quite small. This, in turn, will make total assets appear to be small and
the value of the ratio will be high. This implies that a company with old assets is managing its assets
quite efficiently. In fact, the company may not be managing its assets well at all – they are simply old
and very depreciated. A company that has recently upgraded its assets by investing in newer
equipment may actually be better managed, but its total asset turnover ratio will look inferior to the
company with older assets. In spite of this, the total asset turnover ratio is widely used; it’s simply
important to know of its major deficiency when using it.
III. DEBT (OR LEVERAGE)
The debt, or leverage, ratios measure the ability of the firm to meet the principal and interest payments on its debt. Keep in mind that debt is neither good nor bad; it is simply a tool. There are times that heavy use of it is appropriate (e.g., when sales are going up) and there are times that it is detrimental (when sales are going down). These ratios simply measure the extent to which the company is using debt in financing the company’s assets and whether it has gone too far by using so much debt that it is having difficulty in paying the interest when it is due.
7. Debt Ratio -- Indicates the percentage of the total assets that have been financed by debt.
Total Debt (or Liabilities) Debt Ratio = Total Assets
On the balance sheet, total assets must equal total liabilities and capital. In other words, total assets
are equal to the amount of the company’s debt plus the amount of equity. Looked at another way, the
company is financed with a combination of debt and equity. So this ratio simply measures the
percentage of the total assets that are financed with debt. If the debt ratio is 40%, this means that the
company has financed 40% of its assets with debt (borrowed money) and 60% with equity (investors’
money). This ratio is one way of measuring the financial leverage of the company: the higher the
debt ratio, the higher the degree of financial leverage that the company has.
8. Debt-to-Equity -- A variation of the debt ratio. Measures the money invested by creditors relative to
the money invested by the owners.
Total Debt (or Liabilities)Debt-to-Equity Ratio = Total Equity
This is just another way of measuring the degree of financial leverage. Notice that if the debt ratio is
40%, this means that every $1.00 of total assets is financed with $0.40 in debt and $0.60 in equity. If
we knew that the debt ratio is 40%, could we figure out the value of the debt-to-equity ratio? Sure,
because we know that if debt is 40% of the assets, then equity must be the other 60%. Therefore, the