Financial ratios are indicators of a company’s performance as discernable from the company’s Balance Sheet and income Statement. We will discuss some of the simple ratios of a company and talk about their significance.
Liquidity Ratios: Show the company’s ability to pay of its current liabilities from its current assets.
1. Current Ratio
Current assets should be significantly higher than current liabilities so that the current ratio is higher than 2:1.
2. Quick Ratio (Acid Test Ratio)
Reduces the numerator of the current ratio formula by deducting Inventory (the least liquid of the current assets).
The Numerator should High enough so that the quick ratio is at least 1:1.
Asset Management Ratios: Show the company’s efficiency in using its assets in generating sales. Generally, high asset management ratios indicate high level of efficiency in utilising assets.
1. Average collection Period (ACP)
Shows the average number of days taken by the company to collect its receivables. The lower the ACP, the better.
2. Inventory Turnover Ratio (ITO)
Tells how quickly inventory is converted to sales. The higher the ITO, the better.
3. Fixed Asset Turnover (FAT)
Tells how efficiently fixed assets are used to generate sales. The higher the FAT, the better.
4. Total Asset Turnover (TAT)
Tells how efficiently all assets are used to generate sales. The higher the TAT, the better.
Debt Management Ratios: Show the optimum amount of the firm’s Debt compared to its assets and equity. Debt should not be too high to cause inability to repay them or too low to lose the opportunity to avail low interest rate.
1. Debt to Asset Ratio (D/A)
Debt should be low enough to be covered by its total asset because if incomes are too low assets may have to be sold off to repay the debt.
2. Debt to Equity Ratio (D/S)
No need to explain its implication at this level of studies. We will talk about it when we read courses in financial