What do Financial Ratios tell us

Liquidity Ratios 1. Current Ratio= Current Assets/Current Liabilities

Higher the current ratio, the higher the likelihood that a firm will be able to pay its bills. So, from the creditors point of view, higher is better. However, from a shareholders point of view this is not always the case. Current assets usually have a lower expected return than do fixed assets, so the shareholders would like to see that only the minimum amount of the companys capital is invested in current assets. Of course, too little investment in current assets could be disastrous for both creditors and owners of the firm 2. Quick Ratio (Acid Test Ratio)= (Current Assets-Inventory)/Current Liabilities Quick ratio will always be less than the current ratio. This is by design. However, a quick ratio that is too low relative to the current ratio may indicate that inventories are higher than they should be. Efficiency Ratios 3. Inventory Turnover Ratio= Cost of Goods Sold/ Inventory The inventory turnover ratio measures the number of dollars of sales that are generated per dollar of inventory. It also tells us the number of times that a firm replaces its inventories during a year. Generally, high inventory turnover is considered to be good because it means that storage costs are low, but if it is too high the firm may be risking inventory outages and the loss of customers.

4. Accounts Receivable Turnover Ratio=Credit Sales/Account Receivables higher is generally better, but too high might indicate that the firm is denying credit to creditworthy customers (thereby losing sales). If the ratio is too low, it would suggest that the firm is having difficulty collecting on its sales. This is particularly true if we find that accounts receivable are increasing faster than sales over a prolonged period 5. Average Collection Period=Accounts Receivable/(Annual Credit Sales/360)

lower is usually better, but too low may indicate lost sales. this ratio actually provides us with the same information as the accounts receivable turnover ratio

6. Fixed Asset Turnover Ratio=Sales/Net Fixed Assets 7. Total Asset Turnover Ratio=Sales/Total Assets the total asset turnover ratio describes how efficiently the firm is using its assets to generate sales. We can interpret the asset turnover ratios as follows: Higher is better. However, you should be aware that some industries will naturally have lower turnover ratios than others. For example, a consulting business will almost surely have a very low fixed asset turnover ratio describes the dollar amount of sales that are generated by each dollar invested in fixed assets

investment in fixed assets, and therefore a high fixed asset turnover ratio. On the other hand, an electric utility will have a large investment in fixed assets and a low fixed asset turnover ratio Leverage Ratios: These ratios describe the degree to which the firm uses debt in its capital structure. This is important information for creditors and investors in the firm. Creditors might be concerned that a firm has too much debt and will therefore have difficulty in repaying loans. Investors might be concerned because a large amount of debt can lead to a large amount of volatility in the firms earnings 8. Total Debt Ratio: Total Debt/ Total Assets=(Total Assets-Total Equity)/Total Assets 9. Long Term Debt Ratio=Total Long Term Debt/Total Assets 10. Long Term Debt to Total Capitalization=LTD/(LTD+Common Equity+Preferred Equity) Note that common equity is the total of common stock and retained earnings.

11. Debt to Equity Ratio: Total Debt/Total Equity 12.

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