Inventory turnover relates a measure of sales volume to the average amount of goods on hand to produce this sales volume. Notice that we measure the numerator and denominator in cost rather than sales dollars. When comparing an income statement item and a balance sheet item, we measure both in comparable dollars. You can compute the current ratio by dividing current assets by current liabilities, as follows: The current ratio indicates the ability of a company to pay its current liabilities from current assets, and thus shows the strength of the company’s working capital position. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. Working capital is the excess of current assets over current liabilities. Many of these ratios are beyond the scope of this course however, we will examine the ones in bold, above, which are key to evaluating any business. Help investors and potential investors assess the relative merits of the various stocks in the marketplaceĮarnings yield on common stock price-earnings ratio dividend yield on common stock payout ratio on common stock dividend yield on preferred stock and cash flow per share of common stock Rate of return on operating assets net income to net sales net income to average common stockholders’ equity cash flow margin earnings per share of common stock times interest earned ratio and times preferred dividends earned ratio Show the relationship between debt and equity financing in a companyĮquity (or stockholders’ equity) ratio and stockholders’ equity to debt ratioĪn important measure of a company’s operating success Indicate a company’s short-term debt-paying abilityĬurrent (or working capital) ratio acid-test (quick) ratio cash flow liquidity ratio accounts receivable turnover number of day’s sales in accounts receivable inventory turnover and total assets turnover We set up the dollar amounts of the related accounts or items in fraction form called ratios. These ratios include the following: Ratio These accounts may appear on the same statement or on two different statements. Logical relationships exist between certain accounts or items in a company’s financial statements. To make comparisons easier, it helps to assign numbers to “health.” The following video explains how that can be done. Sometimes it’s not enough to say that a company is in good or bad financial health, especially if you’re trying to compare that company with another one. Financial ratios also enable a company to compare itself to other firms in the same industry and answer questions like “Are the other dog biscuit companies doing about the same as ours?” We can also use them to learn how quickly people pay their bills, how long it takes the company to recover its costs for new equipment, how much cash the company has relative to its debt, and its return (profit) on every dollar the company invests. Financial ratios allow us to look at profitability, use of assets, inventories, and other assets, liabilities, and costs associated with the finances of the business.
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