- Current or Working Capital Ratio,
- Quick Ratio or Acid Test,
- Debt/Equity Percentages,
- Rate of Return on Net Sales, and
- Rate of Return on Owner’s Equity.
- Collection Period,
- Inventory Turnover,
- Times Interest Earned Ratio
To begin with, let's analyze the general utility behind all of these ratios. Have you ever taken note of the first thing you do when you get a test result back? Chances are you figure out what percent you got on that test. For example, look at the following mark for a while, then scroll down: 72/90 Nice mark, but as you look at it, you're really not sure EXACTLY what to think of it. Your mind longs to reduce it to some form of common value, so that you can accurately compare it to every other test that you have ever taken in any subject before. So what do you do? Well, you figure out the percentage you scored on this test... which is: 80% Not bad at all. You will notice that when you look at this figure you suddenly know EXACTLY how you feel about this test mark. You know whether you are pleased or displeased with it, because you know exactly how it compares to all your previous tests. This is the idea behind all of the ratios you will be learning in this lesson. Accountants have created a variey of methods we can use in order to reduce certain financial aspects of a business to common values, so that they can then be accurately compared. We can compare a particular fiscal year to other fiscal years, or we can compare one business to another business. In any case, we will have common values which we can use. So let's look at the values you were working with: The DEBT RATIO: The debt ratio looks at our total debts as a percentage of our total assets. (Or as you put it, your total debts as a percentage of your debts PLUS owner's equity.) The fact is, a large business with a lot of expenseive assets can look, on the outside, to be very successful. However, if a large percentage of those impressive assets were simply purchased on borrowed money, then the business isn't necessarily succesful at all. Consider for a moment your friends who may be home owner's. How do you gage their financial success? Do you look at the value of their homes? Or do you look at the total home value that they have actually paid for? There's a big difference. Friend "A" may live in a $500,000.00 house, but they still owe $450,000.00 on that house. Friend "B" may live in a $250,000.00, yet they only owe $50,000.00 on it. Friend "B" may appear to be less successful, but financial analyses would reveal that they are in fact far MORE successful than friend "A". After all, friend "A" only has 50,000.00 (10%) worth of equity in their house, while friend "B" has $200,000.00 (80%) worth of equity in their home. Businesses are just the same. We don't want to be distracted by the value of the assets alone, so we look at the PERCENTAGE of those assets which the business owners STILL OWE money on. That is the purpose of the debt ratio. Here's a compelling example of how we can draw meaningful comparisons between two very different companies: Company A Assets: $10,000.00 Liabilities: $2,000.00 Equity: $8,000.00 Debt Ratio = 2,000.00 = 20% --------- 10,000.00 This is a pretty low debt ratio. Company A only owes 20 cents on every dollar of assets which they own. Company B Assets: $1,000,000.00 Liabilities: $400,000.00 Equity: $600,000.00 Debt Ratio = 400,000.00 = 40% ------------ 1,000,000.00 This is still an acceptable debt ratio. However, despite the massive differences between these two companies we can clearly see that this company's debt situation is twice as bad as the first company's - as Company B owes 40 cents on every dollar of assets which they own. Hey, it's nice to have a million dollars worth of assets, but that $400,000.00 of debt is quite a ball and chain to drag around. A little reminder about the Debt/Equity Ratio. This expression (Debt/Equity Ratio) is usually used to refer to two different, yet similar ratios at once. The debt ratio (which I explained above) and the equity ratio (which is the exact opposite of the debt ratio.) The equity ratio simply shows us what the Owner's Equity is as a percentage of the total Assets. I will illustrate this ratio using the same example I used for the debt ratio: Company A Assets: $10,000.00 Liabilities: $2,000.00 Equity: $8,000.00 Equity Ratio = Equity ------ Assets Equity Ratio = 8,000.00 = 80% --------- 10,000.00 This is a pretty good equity ratio. Company A has 80 cents of equity in every dollar of assets which they own. Company B Assets: $1,000,000.00 Liabilities: $400,000.00 Equity: $600,000.00 Equity Ratio = Equity ------ Assets Equity Ratio = 600,000.00 = 60% ------------ 1,000,000.00 This is still an acceptable equity ratio. However, despite the massive differences between these two companies we can clearly see that this company's equity situation is 20% lower than Company A's - as Company B has only 60% equity in every dollar of assets which they own. Times Interest Earned Ratio: This ratio is simply looking at the company's Net Income as a percentage of the total money it spends on interest charges. Interest here refers to the total COST associated with carrying the company's liabilities. So we are talking about interest we have been charged on mortgages, loans, and account payables for the year. Once again, consider a personal situation first. What if you had a credit card loan that was costing you $100.00 a month in interest alone! Not a very good situation. However, if you are able to bring home $2,000.00 a month from your salary, you could probably handle it. However, what if you discovered that a high school student had run up the same credit card bill, and was being charged the same amount in interest? What if this student only earns $80.00 a month from his/her allowance. Do you see the problem here? The high school student doesn't even EARN enough money to pay the interest on the debt! These are two extreme examples, but they illustrate the point we are looking at. Now let's look at two more subtle business examples: Company A Net Income: $5,000.00/year Interest Expense: $250.00/year (10% of $2,000.00) Times Interest Earned = Net Income ---------------- Interest Expense = 5,000.00 -------- 250.00 = 20.0 This isn't bad at all. It shows us that Company A earns 20 times the amount of money which they spend to service their debt. Obviously, they can more than afford the debt which they are carrying. Company B Net Income: $80,000.00/year Interest Expense: $40,000.00/year (10% of $400,000.00) Times Interest Earned = Net Income ---------------- Interest Expense = 80,000.00 --------- 40,000.00 = 2.0 Yeash! This is bad! This shows us that company B only earns 2 times the amount of money which they spend to service their debt! Even though this company earns a lot more money than Company A, half their Net Income is spent on interest charges! Their debt ratio of 40% (see above) didn't look too good, but now that we know how little they earn every year in comparison to the money they spend to carry their debt, we can clearly see that this company's situation is DESPERATE! This company would have an almost impossible time borrowing any additional funds.
- and the Equity Ratio is calculated by the following formula:
