Ratio Definitions

Ratio Definitions
The absence of a particular financial ratio from any record may be due to lack of data or a decision to specifically exclude that ratio. This may be done when certain factors, such as accounting policies, financial statement formats, or the timing of a financial statement, render certain ratios misleading.

Working Capital
Current Assets – Current Liabilities

Working capital is the difference between a company’s current assets and current liabilities, expressed in a total dollar amount. While excess inventory and slow receivable collection can increase working capital without actually improving cash flow, it is generally held that a higher working capital position, along with favorable liquidity ratios, indicates a company is better able to pay its short term obligations within terms.

Example: ABC Company has total current assets of cash, accounts receivable, inventory and prepaid expenses of $1,000.000. Total current liabilities consist of accounts payable, accrued expenses and borrowings on its short term bank line of credit of $500,000. Its working capital is $500,000.

Current Ratio
Current Assets ÷ Current Liabilities

Total current assets divided by total current liabilities is a measure of a company’s ability to pay its short term obligations in the normal course of business. Those assets that are expected to be converted to cash, sold or consumed in the normal business cycle should be sufficient to liquidate liabilities due within the current fiscal year or the business’ normal operating cycle. While a higher ratio can sometimes mean slow receivable collection or excess inventory, it is generally favorable to have a higher current ratio. A less than 1:1 ratio could call into question a company’s ability to pay its short term obligations within terms.

Example: ABC Company has total current assets of $1,000,000 and total current liabilities of $500,000. Its current ratio is 2:1.

Quick Ratio
Cash, Cash Equivalents and Accounts Receivable ÷ Current Liabilities

Considered a more stringent test of a company’s liquidity than the current ratio, this ratio considers only those assets readily convertible to cash to pay current obligations. Generally speaking, like the current ratio, the higher the ratio the better the chances the business will be able to pay its short term obligations within terms.

Example: ABC Company has current assets including cash of $200,000, accounts receivable of $200,000 and marketable securities (publicly traded stocks) valued at $100,000. Current liabilities total $500,000. The quick ratio is 1:1.

Accounts Receivable Turnover
Net Sales ÷ Trade Accounts Receivable

This measures the number of times a company’s accounts receivable turnover in a given year. The higher the number, the more quickly receivables are collected. A low number suggests a company may be having difficulty collecting their own receivables, possibly impairing their ability to pay their suppliers within terms.

Example: ABC Company has annual sales of $2,400,000 and average accounts receivable of $200,000. Their accounts receivable turnover is 12, suggesting they normally collect their receivables within about 30 days (or 1 month).

Days Payable Outstanding
(Accounts Payable x 365) ÷ Cost of Goods Sold

Assuming that virtually all purchasing is done on a credit basis, the days payable outstanding estimates the average number of days it takes a company to pay its accounts payable. Some accounting treatments can cause discrepancies in this figure, so it is important to evaluate this information in conjunction with other financial statement ratios and the company’s specific accounts payable history.

Example: ABC Company has accounts payable of $100,000 and cost of goods sold for the year of $1,400,000. Their days payable outstanding is 26.07 days.

Debt to Equity
Total Liabilities ÷ Total Equity

The debt to equity ratio measures the total debt of the business in relation to the total equity (equity equals the difference between total assets and total debt). The higher the number, the more debt the business carries in relation to invested capital and retained earnings which are the components of equity. Higher debt reduces the possibility of a full payout to creditors in the event of a business liquidation, and also has possible negative cash flow implications due to the cost of carrying and servicing the debt through principle and interest payments.

Example: ABC Company has total assets of $3,000,000, total liabilities of $2,000,000 and equity of $1,000,000. The Debt/Equity ratio is 2:1.

Fixed Assets to Equity
Net Fixed Assets ÷ Total Equity

Fixed assets to equity reveals what portion of the total assets of a business are invested in property, buildings, equipment and the like, in relation to total equity. Certain types of businesses, such as trucking companies and growers, properly tend to be fixed asset intensive. A too high percentage of fixed assets, depending on the type of business, could suggest a lack of liquid assets to pay short term obligations.

Example: ABC Company has fixed assets after depreciation of $1,500,000 and total equity of $1,000,000. Its fixed asset to equity ratio is 1.5:1.

Debt Service Ability
(Net Income + Depreciation + Amortization) ÷ Current Maturity of Long Term Debt

One measure of a company’s ability to pay the current portion of their long term debt (that which is due in the current fiscal year), is to add the net income after taxes and non-cash expenses such as depreciation of fixed assets and amortization, and divide that by the principal payments on long term liabilities due within that year. A less than 1:1 ratio could indicate difficulty paying those obligations within terms. To remedy this without renegotiation, one alternative could involve using funds which would otherwise go to pay trade creditors. The higher the number, the greater the company’s ability to handle its debt service requirements.

Example: ABC Company has $100,000 due this year as part of its long term mortgage and other long term financing. Its net income after taxes for the fiscal year was $75,000 with depreciation expense for the year of $50,000. The Debt Service Ability ratio is 1.25:1.

Operating Ratio
(Cost of Goods Sold + Operating Expenses) ÷ Sales

This is one way of presenting a business’ ability to control expenses and operate profitably. A greater than 1:1 ratio indicates an operating loss for period. The lower the ratio, the greater the operating profit margin. A company’s ability to manage costs, operate efficiently, and turn consistent profits have obvious positive implications for cash flow and payment ability.

Example: ABC Company has annual sales of $2,400,000 with a cost of goods sold of $1,400,000 and additional operating expenses of $400,000. The operating ratio is .75:1.