(ACT) Ratios Lesson

Ratios 

Many financial ratios exist that can give us information about how well a company is doing. We will focus on the basic ratios in three categories: liquidity, profitability, and financial leverage.

Liquidity Ratios

LIQUIDITY RATIOS FOCUS ON THE ABILITY OF A COMPANY TO PAY ITS DEBT IN THE SHORT-TERM, THAT IS LESS THAN A YEAR THREE RATIOS ARE BASIC TO THIS CATEGORY: CURRENT RATIO, QUICK RATIO, AND WORKING CAPITALCurrent Ratio demonstrates the relationship between current assets and current liabilities. The formula is: current assets/current liabilities. It is reported, not as a percentage, but as a ratio such as 2.2:1 (read 2.2 to 1) meaning 2.2 dollars of current assets for every dollar of current liabilities. You would never want to have a ratio of less than 1:1 for your current ratio.

Quick Ratio, like current ratio, examines the relationship between specific current assets, called quick assets, and current liabilities. Quick assets are your most liquid assets (easiest to turn into cash) and include all current assets except for inventory and any prepaid assets. The formula is: quick assets/current liabilities. It is also reported as a ratio. While this ratio may be less than 1:1, the closer to 1:1the ratio is, the better.

Working Capital demonstrates the amount of current assets that would be left to run the company on should all of the current liabilities be paid off. The formula is: current assets-current liabilities. The amount is reported as a whole number, and this number needs to be a positive number.

Profitability Ratios

PROFITABILITY RATIOS FOCUS ON HOW WELL THE COMPANY IS DOING AT MAKING A PROFIT. THESE RATIOS INCLUDE: GROSS PROFIT MARGIN, OPERATING PROFIT MARGIN, AND NET PROFIT MARGIN EACH OF THESE RATIOS ARE REPORTED AS PERCENTAGES HGross Profit Margin compares the gross profit (sometimes called gross margin) to net sales. The formula for this ratio is: [gross profit(margin)/net sales]*100. Reported as a percentage, companies often have a target percentage that they want their gross profit margin to meet.

Operating Profit Margin compares the income from operations with net sales. The formula for this ratio is : [operating profit (also called income from operations)/net sales]*100. This ratio is also reported as a percentage so that it can be compared with the same ratio from other periods or within the industry.

Net Profit Margin compares net income to net sales. In companies where the only revenues are from the sale of goods and services (there is no income from things like rent or investments) the net profit margin will be the same as the operating profit margin. For companies with additional sources of income, the formula for this ratio if (net income/net sales)*100. Like the operating profit margin, this percentage can be compared with in the company for other periods or with the industry.

Financial Leverage

FINANCIAL LEVERAGE ADDRESSES HOW A COMPANY IS USING BORROWED MONEY OR HOW WELL A COMPANY IS ABLE TO PAY ADDITIONAL DEBT. A HIGH FINANCIAL LEVERAGE RATIO PUTS A COMPANY AT RISK FOR BANKRUPTCY. THE COMMON RATIOS USED TO MEASURE FINANCIAL LEVERAGE ARE TOTAL DEBT TO ASSETS RATIO, LONG-TERM DEBT TO ASSETS RATIO, AND TOTAL DEBT TO EQUITY RATIOTotal Debt to Assets Ratio measures the relationship between the total debt and the assets that back up that debt. The formula is: Total Liabilities/Total Assets. This ratio is reported as a ratio. The optimal ratio is 0.5:1 or less. This would indicate that assets were funded mainly through equity (owner investment).

Long-Term Debt to Assets Ratio indicates how much of a company's assets are financed by loans that will take more than a year to repay. The formula for this ratio is Long-Term Debt/Total Assets. Reported as a ratio, the higher the level of long term debt, the more important it is for the company to have positive revenue and a steady cash flow to meet its long-term obligations.

Total Debt to Equity Ratio is the key financial ratio used to determine a company's financial standing. Lenders and investors prefer a company with a low debt to equity ratio because a rising ratio means a company is relying more on borrowing money than on its own resources. The formula for the ratio is Total Debt/Owner's (or Shareholder's) Equity.

Caution should be taken in analyzing all ratios. It is important to note that no ratio stands or has value on its own. It is only in comparing ratios with other times or with the industry average can we get a good sense of how a company is doing.

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