Financial ratios are accounting tools that allow stakeholders to review a company's performance. Different ratio categories exist for testing specific financial information. Two common ratio groups that compare assets to liabilities include liquidity and financial leverage ratios. Stakeholders can compute these ratios each month, when a company releases its financial statements.
The current ratio is the first of three liquidity ratios to compare assets to liabilities. The basic formula is current assets divided by current liabilities. Its purpose is to tell stakeholders what ability a company has to repay short-term liabilities. Ratios over 1 indicate a strong capability to repay these debts. A figure under 1 indicates a weak financial position to repay short-term liabilities.
The quick ratio is similar to the current ratio, except for one piece of information. The formula takes current assets less inventory and divides the figure by current liabilities. This avoids overestimating a company's financial strength by removing inventory, which may sit in a company's warehouse for some time before a company sells it. Again, numbers over 1 indicate strong abilities to pay short-term liabilities and numbers under 1 indicate a weak financial position.
A more conservative approach to either of the previous to ratios is the cash ratio. This formula sums cash, cash equivalents and invested funds, often the most liquid assets in a company. Stakeholders then divide this figure by current liabilities. Results over 1 are strong indicators of financial liquidity while results under 1 are not. This ratio uses on the current cash on hand to ensure the business has the ability to pay off liabilities without selling one more inventory item.
Debt ratio computations present a company's financial leverage. It measures a company's use of debt to finance assets, rather than testing a company's ability to repay obligations. The formula is total debts divided by total assets. Results over 1 indicate a company uses more debt to finance assets. Results under 1 indicate a company uses less debt and more cash to finance these items.
- "Fundamental Financial Accounting Concepts"; Thomas P. Edmonds, et al.; 2011