May 23 2012
How important are these Ratios to your Business?
Accounting ratio is an integral and important aspect of any business compares two aspects of a financial statement, such as the relationship (or ratio) of current assets to current liabilities. The ratios can be used to evaluate the financial condition of a company, including the company’s strengths and weaknesses.
Since it is intended to provide a useful comparison, accounting ratios assist in measuring the efficiency and profitability of a company based on its financial reports.
In the light of the above the import of accounting ratios to a business cannot be overemphasize. Below are some relevant financial ratios that helps measures the strength and weakness of your business with a view to an in-depth SWOT analysis of your business finances.
- Acid Test Ratio or Quick ratio : – This ratio, also called “acid test” or “liquid” ratio, considers only cash, marketable securities (cash equivalents) and accounts receivable because they are considered to be the most liquid forms of current assets. A stringent indicator that determines whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets.
This ratio is calculated by:
It thus means Companies with ratios of less than 1 cannot pay their current liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower than the working capital ratio, it means current assets are highly dependent on inventory. Retail stores are examples of this type of business.
If a company’s financial statements pass the figurative acid test, this indicates its financial integrity.
- Current Ratio – This ratio is a comparison of current assets to current liabilities, commonly used as a measure of short-run solvency, i.e., the immediate ability of a business to pay its current debts as they come due. Potential creditors use this ratio to measure a company’s liquidity or ability to pay off short-term debts. Thist ratio is calculated using the following formula:
Current Assets ÷ Current Liabilities
- Current Liabilities to Net Worth Ratio – This ratio indicates the amount due creditors within a year as a percentage of the owners or stockholders investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80%. This ratio is calculated using the following formula:
Current Liabilities ÷ Net Worth
- Current Liabilities to Inventory Ratio – This ratio shows, as a percentage, the reliance on available inventory for payment of debt (how much a company relies on funds from disposal of unsold inventories to meet its current debt). This ratio is calculated using the following formula:
Current Liabilities ÷ Inventory
- Total Liabilities to Net Worth Ratio – This ratio shows how all of a company’s debt relates to the equity of the owners or stockholders. The higher this ratio, the less protection there is for the creditors of the business. This ratio is calculated using the following formula:
Total Liabilities ÷ Net Worth
- Fixed Assets to Net Worth Ratio – This ratio shows the percentage of assets centered in fixed assets compared to total equity. Generally the higher this percentage is over 75%, the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery and the margin for operating funds becomes too narrow for day-to-day operations. This ratio is calculated using the following formula:
Fixed Assets ÷ Net Worth
- Price-Earnings Ratio – P/E Ratio :- This measures the price paid per share in relation to the profit earned by the company per share in a given year.
It is calculated thus
Market Value per Share divide Earnings per Share (EPS)
For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn’t tell us the whole story by itself. It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.
The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.
It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.
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