Liquidity ratios provide information useful for decision makers to make a judgment of a business ability to meet the short-term obligation. Liquidity ratios are key to credit givers.
Current ratio (or working capital ratio) evaluates current assets to current liability. The high current ratio indicates less risk investment to short-term credit givers. However, shareholders prefer lower current ratio as it shows businesses’ current assets are working to grow the business. When comparing the current ratio of different businesses consider the size, type of inventory, length of operation and industry.
Quick ratio (or acid test ratio) does not include inventories like the current ratio.
Quick ratio = (current asset – inventory) / current liability
A current asset in quick ratio includes cash, account receivables, and note receivables (Internet Center for Management and Business Administration Inc., 2010).
Cash ratio looks at the most liquid asset.
Cash ratio = (cash + market securities) / current liabilities
When immediate payment is required, the cash ratio provides a clear representation.
Leverage ratio provides information of long-term solvency of the business. It paints a picture of the extent to which business is using long-term assets.
Debt ratio = (total debt / total assets)
Debt-to-equity ratio = (total debt / total equity)
Debt ratios depend classification of long-term leases and some long-term equity or debt.
When looking at how earnings by the business cover interest on debt, we evaluate time interest earned ratio.
Interest coverage = EBIT/interest charged
Profitability ratios show how the business has succeeded in making profits at different levels.
Gross margin profit = (sales – COGS) / sales
Gross margin profits measures profit from sales.
Return on assets = Net income / Total assets
Return on assets ratio measures profit from the effective use of its assets.
Return on equity = Net income / total shareholder’s equity
Return on equity ratio measures profits from every amount invested by the shareholders.
Market measure ratios
Market measure ratio or market prospect ratio as referred by My Accounting Course (2016), are used to compare publicly traded companies’ stock prices with other financial measures like earnings and dividend rates (what they expect to receive from their investment).
Earnings per share = (net income–preferred dividend) / Weighted average common shares outstanding
Price earnings ratio = market value price per share / earnings per share
Dividend payout ratio = dividends per share / earning per share
Dividend yield = dividend per share / share price