Financial Ratios

Common Size statements

A common size statement as the name implies is when we give a common size to financial statements in order to compare two different sized firms and to examine trends over time within a single firm.

Common size statements normalize balance sheets and income statement items to allow easier comparisons of different sized firms. A common size balance sheet expresses all balance sheet account as a percentage of total assets, and expresses all income statement items as a percentage of sales. In lay man terms, it is a financial statement in which the dollar figures have been converted into percentages.

 

Liquidity Ratios

Current ratio: It is a short term indicator of the company’s ability to pay its short term liabilities from short term assets; in other words, it asks the question “how much of current assets are avialable to cover each dollar of current liabilities. The formula for calculating the current ratio is:

 

Quick ratio: It is almost similar to current ratio, but without inventories because inventories are quite illiquid and may not be easily converted into cash. So the quick ratio relates current liabilities to only relatively liquid current assets. It measures the company’s ability to pay off its short term obligations from current assets excluding inventories.

The formula for the quick ratio is

 

Inventory to net working capital: This ratio measures the extent to which the cushion of excess current assets over current liabilities may be threatened by unfavourable changes in inventory.

 

Cash ratio: This ratio relates the firm’s cash and short term marketable securities to its current liabilities. It measures the extent to which the company’s cash capital is in cash or cash equivalents; shows how much of the current obligations can be paid from cash or near cash assets.

 

Activity Ratios

Debtors/ receivable turnover: This ratio is used to calculate how fast a company’s debtors are in paying back the money owed. It indicates the number of times account receivables are cycled during the period (usually a year). The formula is:

 

Average collection period: This ratio is used to determine the number of days during a 365 day period that the firm collects amount owed to them from debtors. It indicates the average length of time in days that a company must wait to collect a sale after making it;may be compared to the credit terms offered by the company to its customers. The formula is

 

Inventory Turnover: This ratio measures the number of times average inventory of finished goods was turned over or sold during a period of time, usually one year.

The formula

 

Where average inventory is: