How to Calculate Financial Ratios

Calculating financial ratios provides vital information not only to the owners of a company, but also to those holding potential interests, such as short and long-term creditors, investors and shareholders. Financial ratios can also be used to compare company financials with those of the competition, to analyze market trends, and to facilitate educated decisions based upon highly intuitive calculations. Financial ratios fall into three main categories, with each providing very specific information. The first category, Liquidity Ratios, indicates a company's ability to meet its short-term obligations using liquid assets. The second category, Financial Leverage Ratios, ultimately indicates if a company will be financially able to handle its long-term responsibilities. The final category, Profitability Ratios, paints an overall picture of how adept a company is at creating its "worth" or financial value.Now that we know the importance of tracking and monitoring financial ratios, it's time to do the math using the categorized formulas that follow. Typically, company income statements, balance sheets and cash-flow statements contain the entries needed to accurately calculate financial ratios.

Things You'll Need

• Prepared income statement
• Balance sheet
• Cash-flow statement
• Calculator

Instructions

Formulas for Liquidity Ratios (Short-Term Obligations)

1. The Current Ratio (or Working Capital) is the ratio of current assets to current liabilities. Working capital is a company's biggest safety net against financial disaster.Current Ratio = current assets / current liabilities

2. The Quick Ratio (or Acid Test) is considered more stringent than the Current Ratio. In this formula, inventories and paid expenses are removed from the current assets because they often can not be turned back into cash or liquidated quickly.Quick Ratio = (cash + investments + receivables) / current liabilities

3. The most conservative Liquidity Ratio, the Cash Ratio only allows cash assets or the equivalent. This ratio indicates a company's ability to pay off a debt instantly upon demand.Cash Ratio = cash + marketable securities / current liabilities

4. The Inventory Turnover (or, simply, Inventory Turn) divides the cost of goods sold (from a yearly income statement) by the average value of inventories (end of year balance sheet). This ratio is a good indicator of actual inventory liquidity.Inventory Turnover = cost of goods / inventories

5. The Receivables Turnover provides liquidity information by dividing the sales made on credit by the average accounts receivables.Receivables Turnover = sales on credit / accounts receivable

Formulas for Financial Leverage Ratios (Long-Term Responsibilities)

1. The Debt Ratio is derived by subtracting the company's total assets from its total debt.Debt Ratio = total debt / total assets

2. The Debt to Equity Ratio is a comparison of the firm's total debt and total equity.Debt to Equity Ratio = total debt / total equity.

3. Also called the Interest Coverage, the Times Interest Earned Ratio measures a company's ability to handle the interest payments of long-term debt.Times Interest Earned Ratio = earnings before interest (EBIT) / interest charges

Formulas for Profitability Ratios

1. The Gross Profit Margin is derived by subtracting the cost of good sold from sales and then dividing the result by sales.Gross Profit Margin = (sales - cost of goods sold) / sales

2. The Return on Investment ratio measures a company's ability to use assets to generate profits.Return on Investment = net income / total Assets

3. The Return on Equity ratio represents the amount left over (ROE) after debt interest expense is paid from profits.Return on Equity = net income / owner's equity

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