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Ratios to Measure Returns on Investments
| 1. Return on Equity |
Ratio
Net income (Income Statement)
------------------------------------------------------------
Average stockholders' equity (Balance Sheet) |
Example
465,000
------------------------------------------------------ = 9.2%
((5,239,000+4,860,000)÷2) |
Measures the return on the investment made by the owners.
| 2. Return on Assets |
Ratio
Net income (Income Statement)
------------------------------------------------------------
Average total Assets (Balance Sheet) |
Example
465,000
------------------------------------------------------ = 4.1%
((11,636,000+11,004,000)÷2) |
Measures return on the gross investment in the business, including that financed by the owners as well as that financed by the creditors. The relationship between the returns on assets and on equity is indicative of the effect of the business's financial leverage - if the leverage is positive, the return on equity will be greater than the return on assets.
Ratios to Measure Safety and Liquidity
| 1. Net working capital |
Ratio
Current assets (Balance Sheet)
- Current liabilities (Balance Sheet) |
Example
$2,292,000-$1,924,000 = $368,000 |
Indicates the ability to meet short-term obligations, reporting the excess of current assets over current liabilities.
| 2. Current ratio |
Ratio
Current assets (Balance Sheet)
------------------------------------------------------------
Current liabilities (Balance Sheet) |
Example
$2,292,000
------------------------------------------------------ = 1.91:1
$1,924,000 |
Also indicates the ability to pay current liabilities as they mature, providing the ratio of current assets to current liabilities. A ratio of 1:1 or greater corresponds to positive net working capital.
| 3. Debt to equity ratio |
Ratio
Total Liabilities (Balance Sheet)
------------------------------------------------------------
Stockholders' equity (Balance Sheet) |
Example
$6,397,000
--------------------------------------------------- = 1.22 times
$5,239,000 |
Indicates the balance between total equity ownership (common and preferred stockholders) and amounts due to creditors. The greater the number, the "more leveraged" is the company.
| 4. Times interest earned |
Ratio
Income before interest and taxes (Income Statement)
-----------------------------------------------------------------
Interest expense (Income Statement) |
Example
$840,000+$242,000
--------------------------------------------------- = 4.5 times
$240,000 |
Measures the ability of a company to cover the payment of interest to creditors.
| 5. Debt service ratio |
Ratio
Income before interest and taxes (Income Statement)
-----------------------------------------------------------------
Interest expense plus amounts of scheduled debt repayments (Income Statement & Statement of Cash Flows) |
Example
$840,000+$242,000
--------------------------------------------------- = 1.9 times
$242,000+$322,000 |
This ratio is an indicator of the company's ability to pay both the interest and the current principal installments on its outstanding debt and suggests the degree of safety for creditors concerning currently due debt service obligations.
Ratios to Measure Operating Efficiency
| 1. Collection Period |
Ratio
Average account receivable (Balance Sheet)
-----------------------------------------------------------------
Average daily sales (Income Statement) |
Example
((1,178,000+1,175,000)÷2) 1,176,500
----------------------------------- = ------------ = 53.4 days
(7,934,000 ÷360) 22,039 |
Measures the number of days' sales that are uncollected in average accounts receivable, providing an idea of how successful the firm is in collecting its customer debt.
| 2. Receivable turnover ratio |
Ratio
Total sales (Income Statement)
-----------------------------------------------------------------
Average accounts receivable (Balance Sheet) |
Example
7,934,000
--------------------------------------------------- = 6.7 times
((1,178,000+1,175,000)÷2) |
An alternative, but equivalent, measure of the efficiency of the company's receivable collection efforts. If the company also makes sales for cash, "total credit sales" should be substituted for "total sales".
| 3. Number of days sales in inventory |
Ratio
Average inventory (Balance Sheet)
-----------------------------------------------------------------
Average daily cost of sales (Income Statement) |
Example
((458,000+424,000)÷2) 441,000
----------------------------------- = ------------ = 23.3 days
(6,816,000 ÷360) 18,933 |
An indicator of the amount of inventory maintained relative to the company's sales (as measured by cost of goods sold).
| 4. Inventory turnover ratio |
Ratio
Cost of goods sold (Income Statement)
-----------------------------------------------------------------
Average inventory (Balance Sheet) |
Example
6,816,000
--------------------------------------------------- = 15.5 times
((458,000+424,000)÷2) |
An alternative measure of how quickly inventory is sold. |
