# Ratio Analysis

Pages: 10 (2128 words) Published: May 11, 2013
Ratio Analysis
Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one company or to compare two or more companies at one point in time. Financial statement ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency. Liquidity ratios

Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs. Current ratio. The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities. |

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| 20X1 | 20X0 |
Current assets| \$38,366| \$38,294|
Current liabilities| 27,945| 30,347|
Current ratio| 1.4 : 1| 1.3 : 1|
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This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory. Acid-test ratio. The acid-test ratio is also called the quick ratio. Quick assets are defined as cash, marketable (or short-term) securities, and accounts receivable and notes receivable, net of the allowances for doubtful accounts. These assets are considered to be very liquid (easy to obtain cash from the assets) and therefore, available for immediate use to pay obligations. The acid-test ratio is calculated by dividing quick assets by current liabilities. |

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| 20X1 | 20X0 |
Cash| \$6,950| \$6,330|
Accounts receivable, net| 18,567 | 19,230 |
Quick Assets| \$25,517 | \$25,560 |
Current Liabilities| \$27,945 | \$30,347 |
aAcid-test ratio| .9 : 1 | .8 : 1 |
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The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires further analysis of receivables to understand how often the company turns them into cash. It may also indicate the company needs to establish a line of credit with a financial institution to ensure the company has access to cash when it needs to pay its obligations. Receivables turnover. The receivable turnover ratio calculates the number of times in an operating cycle (normally one year) the company collects its receivable balance. It is calculated by dividing net credit sales by the average net receivables. Net credit sales is net sales less cash sales. If cash sales are unknown, use net sales. Average net receivables is usually the balance of net receivables at the beginning of the year plus the balance of net receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly. |

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Calculation of Receivables Turnover | 20X1 | 20X0 | 20W9 | Net credit sales| \$129,000| \$97,000| |
Accounts receivable| 18,567| 19,230| \$17,599|
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Average receivables| (18,567+19,230)/2= | (19,230+17,599)/2= | | | 18,898.5| 18,414.5| |
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Receivables turnover| \$129,00/\$18,898.5 = | \$97,00/\$18,414.5 = | | | 6.8 times| 5.3 times| |
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Average collection period. The average collection period (also known as day's sales outstanding) is a variation of receivables turnover. It calculates the number of days it will take to collect the average receivables balance. It is often used to evaluate the effectiveness of a company's credit and collection policies. A rule of thumb is the average collection period should not be significantly greater than a company's credit term period. The average collection period is calculated...