courses › Accounting

Financial Ratios

level 38 course

Liquidity, leverage, collection speed, and returns, each with its limits.

Pen and paper is fine · no calculator needed why?

Opens at level 38.

Builds on: The Balance Sheet (not open yet) · Margins on the P&L (not open yet)

the lesson

The idea, the techniques and a tip for each skill, right here. The Learn page adds worked examples for every skill and untimed practice.

Read the lesson · about 3 minutes

The idea

A ratio compares two figures from the statements, so you can judge a business of any size. Each one answers a single question, so read it as a clue, not a verdict.

The current ratio asks whether current assets cover what comes due within a year. The quick ratio asks the same using only cash and receivables, since inventory can be slow to sell. Debt-to-equity compares what the business owes with what the owners have in. Days sales outstanding counts the days of sales still waiting to be collected. Return on equity is the profit each dollar of equity earned.

Techniques

Put the right number on top

Current ratio, quick ratio or debt-to-equity.

Current ratio: current assets ÷ current liabilities.
Quick ratio: only cash plus receivables on top.
Debt-to-equity: total liabilities ÷ equity.
Divide, never subtract.

worked example

Example: Cash is $3,000, accounts receivable $5,000, inventory $6,000, and current liabilities $10,000. What is the quick ratio (cash plus receivables, divided by current liabilities)?

Leave out inventory.
($3,000 + $5,000) ÷ $10,000 = 0.8.

Answer: 0.8

Days of sales waiting

Annual credit sales and receivables are given.

Daily sales: annual credit sales ÷ 365.
Divide receivables by daily sales.

worked example

Example: Annual credit sales are $365,000 and accounts receivable is $40,000. Using a 365-day year, what is days sales outstanding, in days?

Daily sales: $365,000 ÷ 365 = $1,000.
Days: $40,000 ÷ $1,000 = 40.

Answer: 40

Return on equity

Net income and owners' equity are given.

Use net income, the bottom line.
Divide by equity and multiply by 100.

worked example

Example: Net income for the year is $12,000 and owners' equity is $80,000. What is return on equity?

$12,000 ÷ $80,000 = 0.15 = 15%.

Answer: 15%

Tips by skill

TipCurrent ratio: Current assets divided by current liabilities, given as a plain number. A snapshot, not a promise the bills get paid.
TipQuick ratio: Cash plus receivables, divided by current liabilities. Leave out inventory and anything prepaid.
TipDebt-to-equity: Total liabilities divided by equity: dollars owed for each dollar the owners have in.
TipDays sales outstanding: Divide annual credit sales by 365 for daily sales, then divide receivables by that.
TipReturn on equity: Net income divided by owners' equity, times 100.

Watch out for

Subtracting instead of dividing. Current assets minus current liabilities is working capital, not a ratio.
Dividing upside down, like equity over liabilities for debt-to-equity.
Counting inventory in the quick ratio.
Using revenue or operating profit for return on equity instead of net income.

skills · practice stats

From rounds of this course only: box, review and test-out answers are left out. Once a skill has 40 tries, it compares your first 20 tries with your last 20.

Current ratio par 12 s not tried yet
worked example
Current assets are $70,800 and current liabilities are $59,000. What is the current ratio? (Give it as a number, like 1.75.)

Answer: 1.2
1. Current ratio = current assets ÷ current liabilities = $70,800 ÷ $59,000 = 1.2 (1.2 to 1).
2. It's a snapshot; it doesn't show whether customers will pay in time.
Quick ratio par 16 s not tried yet
worked example
Cash is $18,000, accounts receivable $39,000, inventory $11,000, and current liabilities $47,500. What is the quick ratio (cash plus receivables, divided by current liabilities)?

Answer: 1.2
1. Leave out inventory, which can be slow to turn into cash:
2. ($18,000 + $39,000) ÷ $47,500 = $57,000 ÷ $47,500 = 1.2.
Debt-to-equity par 13 s not tried yet
worked example
Total liabilities are $300,000 and equity is $100,000. What is the debt-to-equity ratio? (Give it as a number, like 1.75.)

Answer: 3
1. Debt-to-equity = liabilities ÷ equity = $300,000 ÷ $100,000 = 3.
2. That's $3 owed for every $1 the owners have in.
Days sales outstanding par 19 s not tried yet
worked example
Annual credit sales are $474,500 and accounts receivable is $78,000. Using a 365-day year, what is days sales outstanding, in days?

Answer: 60
1. Daily sales = $474,500 ÷ 365 = $1,300.
2. DSO = $78,000 ÷ $1,300 = 60 days of sales waiting to be collected.
Return on equity par 13 s not tried yet
worked example
Net income for the year is $12,500 and owners' equity is $100,000. What is return on equity?

Answer: 12.5%
1. ROE = net income ÷ equity = $12,500 ÷ $100,000 = 0.125 = 12.5%.
2. Each dollar the owners have in earned 12.5 cents this year.

rest ladder

Win 3 of your last 4 rounds and the course rests. A win is 90% right, within 2× the round's par. Pass the review when it comes back and the next rest is longer.

1 day
3 days
7 days
14 days
30 days
60 days
mastered · every 90 days

your rounds

No rounds yet.