Notes of Financial Ratios
Financial Ratios
Definition: A number from a financial statement that has been divided by another number. “A financial number presented as a reference with respect to another”
Choice of scale is crucial
The denominator of a financial ratio must be relevant and provide the right feedback to the analyst
Return on Equity- ROE
ROE= net income/ stockholders equity
How much equity has been invested in the company to generate income
Short Term Liquidity Ratios
Liquid Assets
Have secondary markets and can be sold for cash with minimal loss
An asset is more liquid when it can be sold with minimal loss
As we examine a company’s liquidity position we are trying to understand whether the firm can pay its bills if cash from operations is insufficient to pay short term obligations. Can a company turn current assets into cash quickly without a loss of value
Insolvency: inability to pay debts when they are due
Therefore short term liquidity ratios are also known as short term solvency ratios
2 most important short term liquidity ratios: Current Ratio and Quick Ratio
Current Ratio
The ratio of current assets to current liabilities
How well is a company’s current assets performing compared to its current liabilities
Current Ratio = Current Assets / Current Liabilities
In general Current Ratio must be greater than one.
The higher the current ratio of a company the more liquid it is
What does it mean?
To Creditors: it means that companies with high current ratio have the ability to make payments to loans/debts
To Stockholders: High liquidity is not a good sign. High liquidity mean that a company has too much money tied up in current assets and leaving less cash flow for investors
Quick Ratio/ Acid-Test Ratio
Similar to current ratio but inventory is subtracted from current assets in the calculation
This calculation exist due to the fact that inventory is generally not as liquid as other assets
Inventory can generally be sold for cash but with a loss