Financial Ratios
Liquidity, leverage, collection speed, and returns, each with its limits.
Pen and paper is fine · no calculator needed why?
Opens at level 38. You're level 1. You can read and practice here now.
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: current assets ÷ current liabilities.
- Quick ratio: only cash plus receivables on top.
- Debt-to-equity: total liabilities ÷ equity.
- Divide, never subtract.
worked 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
- Daily sales: annual credit sales ÷ 365.
- Divide receivables by daily sales.
worked 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
- Use net income, the bottom line.
- Divide by equity and multiply by 100.
worked 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%
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.
practice
Current ratio
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
- Current ratio = current assets ÷ current liabilities = $70,800 ÷ $59,000 = 1.2 (1.2 to 1).
- It's a snapshot; it doesn't show whether customers will pay in time.
Quick ratio
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
- Leave out inventory, which can be slow to turn into cash:
- ($18,000 + $39,000) ÷ $47,500 = $57,000 ÷ $47,500 = 1.2.
Debt-to-equity
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
- Debt-to-equity = liabilities ÷ equity = $300,000 ÷ $100,000 = 3.
- That's $3 owed for every $1 the owners have in.
Days sales outstanding
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
- Daily sales = $474,500 ÷ 365 = $1,300.
- DSO = $78,000 ÷ $1,300 = 60 days of sales waiting to be collected.
Return on equity
worked example
Net income for the year is $12,500 and owners' equity is $100,000. What is return on equity?
Answer: 12.5%
- ROE = net income ÷ equity = $12,500 ÷ $100,000 = 0.125 = 12.5%.
- Each dollar the owners have in earned 12.5 cents this year.