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Reading Financial Statements with an Analytical Eye 
by kmhagen June 10, 2005

Types of ratios

Some of the different types of ratios that can be calculated from data in the financial statements and used to evaluate a business include:

  • Liquidity ratios
  • Solvency ratios
  • Activity ratios
  • Profitability ratios

Liquidity ratios

Liquidity ratios measure a business’s ability to cover its obligations, without having to borrow or invest more money in the business. The idea is that there should be sufficient cash and assets that can be readily converted into cash to cover liabilities as they come due.

One of the most common liquidity ratios is:

Current Ratio = Current Assets / Current Liabilities

Current assets basically include cash, short-term investments and marketable securities, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable to vendors and employees, and installments on notes or loans that are due within one year. This ratio could also be seen as a measure of working capital – the difference between current assets and current liabilities. A company with a lot of working capital will be in a better position to expand and improve its operations. On the contrary, a company with negative working capital does not have sufficient resources to meet its current obligations, and therefore is not in a position to take advantage of opportunities for growth.

Another stringent test of liquidity is the:

Acid-test Ratio = Current Assets minus Inventories / Current Liabilities

Inventory is a current asset that may or may not be quickly converted into cash. This depends on the rate at which inventory is being turned over. By excluding inventory, the acid-test ratio only considers that part of current assets that can be readily converted into cash. This ratio, also called the Quick Ratio, tells how much of the business's short-term debt can be met by using the company's liquid assets at short notice.

A ratio that shows how many times inventory is turned over, or sold during the period is:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

A high turnover ratio is a sign that products are being produced and sold quickly during the period. A ratio of 1.0, for example, would mean that at any given time you have enough inventory on hand to cover sales for the entire period. The higher this ratio, the more quickly inventory is being turned over and producing assets that are more liquid -- accounts receivable and then cash.

If you want an even clearer idea of exactly how much ready cash is on hand to cover current liabilities, you can use the:

Cash ratio = Cash + Marketable securities / Current Liabilities

The cash ratio measures the extent to which a business could quickly cover short-term liabilities, and therefore is of particular interest to short-term creditors. A ratio of 1.0 would indicate that all current liabilities would be covered at any average point in time by cash and marketable securities that could be readily sold and converted to cash. A ratio of less than 1.0 would mean that other assets, such as accounts receivable or inventory, would have to be converted to cash to cover short-term obligations. A ratio of greater than 1.0 means that there is more than enough cash on hand.



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