RATIO ANALYSIS

Working Capital
Current Assets
– Current Liabilities
= Working Capital
• Subject to understatement if certain assets are
understated (i.e., LIFO inventory)
• Longitudinal comparison appropriate
• Inter-firm comparison is of no value
 Acid-Test (Quick)
Current Ratio
Ratios
Current Assets Current Assets - Inventory
Current Liabilities Current Liabilities

 Cash Equivalents 
 + Marketable Securities 
 + Net Receivables 
 
Current Liabilities
Days’ Sales in Inventory
Ending Inventory
 Cost of Goods Sold 
 
 365 
• Indicates the length of time needed to sell all inventory on hand
• Use of a natural business year
• Understates number of day’s sale in inventory
• Overstates liquidity of inventory
• Implications of extremes
• High: excessive inventory for sales activity
• Low: inventory shortage and lost sales
Inventory Turnover
Cost of Goods Sold
Average Inventory
• Indicates the liquidity of inventory
• Determining average inventory
• End of year and beginning of year base points for average
mask seasonal fluctuations
• Internal analysis: use monthly or weekly amounts
• External analysis: use quarterly data
Net Profit Margin
Net Income Before Noncontrolling Interest,
Equity Income, and Nonrecurring Items
Net Sales
• Also referred to as return on sales
• Reflects net income dollars generated by each dollar of sales
• Potential distortion
• Net “other” income or loss
Total Asset Turnover
Net Sales
Average Total Assets

• Measures the activity of the assets and the ability

of the firm to generate sales through the use of the
assets
• Potential distortion
• Investments
• Construction in progress
• Other assets that do not relate to net sales
Return on Assets
Net Income Before Noncontrolling Interest
and Nonrecurring Items
Average Total Assets

• Measures the ability to utilize assets to create

profits
• Average total assets
• Internal analysis: month-end amounts
• External analysis: beginning and ending amounts
• If necessary, consistent use of end-of-year amounts