 16 Financial Ratios for Business Managers to Know - dummies

# 16 Financial Ratios for Business Managers to Know

You’ll often gain great insights into financial data if you use financial ratios to explore relationships between amounts shown on the financial statements. Here are 16 of the most common financial ratios business managers use.

## Current ratio

The current ratio liquidity measure compares a firm’s current assets with its current liabilities. A firm’s current assets include cash, inventory, accounts receivable, and any other asset that can or will be quickly turned into cash.

The following is the exact formula used to calculate the current ratio:

`current assets/current liabilities`

Here is a general guideline concerning current ratios: A firm’s current ratio should be a value of 2 or higher.

## Acid test ratio

Also known as the quick ratio, the acid test ratio is a more severe measure of a firm’s liquidity. However, it serves the same general purpose as the current ratio. The acid test ratio indicates how easily a firm can meet its current financial obligations and exploit any financial opportunities that pop up.

The following formula is used for calculating the acid test ratio:

`(current assets–inventory)/current liabilities`

Here is a guideline for acid test ratio: A firm’s acid test ratio should be a value of 1 or higher.

## Debt ratio

The debt ratio simply shows the firm’s debt as a percentage of its capital structure. The term capital structure refers to the total liabilities and owner’s equity amount.

The formula for calculating the debt ratio is a simple one:

`total debt/total assets`

No guideline exists for debt ratio because appropriate debt ratios vary by industry and by the size of the firm in an industry.

## Debt equity ratio

A debt equity ratio compares a firm’s long-term debt with a stockholder’s equity or owner’s equity. Essentially, the debt equity ratio expresses a firm’s long-term debt as a percentage of its owner’s equity.

The following is the formula used to calculate a debt equity ratio:

`long-term debt/stockholder's equity`

There’s no real guideline for a debt equity ratio. You simply compare your debt equity ratio with the debt equity ratios of other, similar-size firms in your industry.

## Times interest earned ratio

The times interest earned ratio indicates how easily a firm pays interest expenses incurred on its debt. The following formula is used for calculating the times interest earned ratio:

`operating income/interest expense`

No standard guideline exists for the times interest earned ratio. Obviously, however, the times interest earned ratio should indicate that a firm can easily pay its interest expense.

## Fixed-charges coverage ratio

The fixed-charges coverage ratio resembles the times interest earned ratio. The fixed-charges coverage ratio calculates how easily a firm pays not only its interest expenses, but also any principal payments on loans and any other obligations for which a firm is legally obligated to pay.

The fixed-charges coverage ratio uses the following formula:

`income available for fixed charges/fixed charges`

No guideline exists to specify what your fixed-charges coverage ratio should be. In fact, it is particularly difficult to get the information necessary to think about fixed-charge coverage ratios because fixed charges don’t clearly appear in the standard set of simple financial statements.

## Inventory turnover ratio

The inventory turnover ratio measures how many times in an accounting period the inventory balance sells out. The formula is as follows:

`cost of goods sold/average inventory`

No guideline exists for inventory turnover ratios. A good inventory turnover ratio depends on what your competitors are doing within your industry.

## Days of inventory ratio

The days of inventory ratio resembles the inventory turnover financial ratio; it estimates how many days of inventory a firm is storing. The ratio uses the following formula:

`average inventory/(annual cost of goods sold/365)`

The general rule is that you turn around your inventory just as quickly as your competitor does.

## Average collection period ratio

The average collection period ratio shows how long it takes for a firm to collect on its receivables. You can think about this ratio as a measure of the quality of a firm’s credit and collection procedures. In other words, this ratio shows how smart a firm is at deciding to whom to extend credit. This ratio also shows how effective a firm is in collecting from customers.

The average collection period ratio formula looks like this:

`average accounts receivable/average credit sales per day`

The guideline about the average collection period is that it should tie to your payment terms. If your average number of days of credit sales in accounts receivable equals 60, for example, your payment terms should probably be something like net 60 days (which means customers are supposed to pay you in 60 days or less).

## Fixed-asset turnover ratio

The fixed-asset turnover ratio quantifies how efficiently a firm employs its fixed assets. Predictably, this financial ratio is most useful when a firm has a lot of fixed assets: real estate, equipment, and so forth.

The fixed-asset turnover ratio uses the following formula:

`sales/fixed assets`

As is the case with many of these financial ratios, no guideline exists that you can use to determine a good fixed-asset turnover ratio. You compare your fixed-asset turnover ratio with those of firms of a similar size in your industry.

## Total assets turnover ratio

The total assets turnover ratio also measures how efficiently you’re employing your assets. This ratio is probably more appropriate in the situation where a firm doesn’t have a lot of fixed assets, but the firm still wins or loses at the game of business based on how well the firm manages its assets.

The total assets turnover ratio formula is as follows:

`sales/total assets`

The total assets turnover ratio that you calculate for your business can’t be compared with some external benchmark or standardized rule. You compare your ratio with the same ratio of similar-size businesses in your industry.

## Gross margin percentage

Also known as the gross profit margin ratio, the gross margin percentage shows how much a firm has left over after paying its cost of goods sold. The gross margin is what pays the operating expenses; financing expenses (interest); and, of course, the profits.

The gross margin percentage ratio uses the following formula:

`gross margin/sales`

No guideline exists for what a gross margin percentage should be. Some firms enjoy very high gross margins. Other firms make good money even though the gross margin percentages are very low. In general, of course, the higher the gross margin percentage, the better.

## Operating income/sales

In the case of the business shown earlier in Table 1-2, where operating income equals \$60,000 and sales equal \$150,000, you calculate the net operating margin percentage by using this formula:

`\$60,000/\$150,000`

This formula returns the value 0.4. A 0.4 operating margin percentage, which is equivalent to 40 percent, indicates that a firm’s operating income equals 40 percent of its sales.

No guideline exists for what a net operating margin percentage should be.

## Profit margin percentage

The profit margin percentage works like the net operating margin percentage; it expresses the firm’s net income as a percentage of sales, as shown in the following formula:

`net income/sales`

## Return on assets

The return on assets shows the return that the firm delivers to stockholders and the interest that the firm pays to lenders as the percentage of the firm’s assets. Some businesses use return on assets to evaluate the business’s profitability. (Banks do this, for example.)

The actual formula is

`(net income + interest)/total assets`

## Return on equity

The return on equity financial ratio expresses a firm’s net income as a percentage of its owner’s equity or shareholders’ equity. (Shareholders’ and owner’s equity are the same thing.)

The formula, which is deceptively simple, is as follows:

`net income/owner's equity`