Financial Ratio Analysis 101

Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one company or to compare two or more companies at one point in time. Financial statement ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency.



Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs.

Current ratio. The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities.

This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory.

Acid-test ratio. The acid-test ratio is also called the quick ratio. Quick assets are defined as cash, marketable (or short-term) securities, and accounts receivable and notes receivable, net of the allowances for doubtful accounts. These assets are considered to be very liquid (easy to obtain cash from the assets) and therefore, available for immediate use to pay obligations. The acid-test ratio is calculated by dividing quick assets by current liabilities.

The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires further analysis of receivables to understand how often the company turns them into cash. It may also indicate the company needs to establish a line of credit with a financial institution to ensure the company has access to cash when it needs to pay its obligations.

Receivables turnover. The receivable turnover ratio calculates the number of times in an operating cycle (normally one year) the company collects its receivable balance. It is calculated by dividing net credit sales by the average net receivables. Net credit sales is net sales less cash sales. If cash sales are unknown, use net sales. Average net receivables is usually the balance of net receivables at the beginning of the year plus the balance of net receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.



Profitability ratios measure a company's operating efficiency, including its ability to generate income and therefore, cash flow. Cash flow affects the company's ability to obtain debt and equity financing.

Profit margin. The profit margin ratio, also known as the operating performance ratio, measures the company's ability to turn its sales into net income. To evaluate the profit margin, it must be compared to competitors and industry statistics. It is calculated by dividing net income by net sales.

Asset turnover. The asset turnover ratio measures how efficiently a company is using its assets. The turnover value varies by industry. It is calculated by dividing net sales by average total assets.

Return on assets. The return on assets ratio (ROA) is considered an overall measure of profitability. It measures how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio.

Return on common stockholders' equity. The return on common stockholders' equity (ROE) measures how much net income was earned relative to each dollar of common stockholders' equity. It is calculated by dividing net income by average common stockholders' equity. In a simple capital structure (only common stock outstanding), average common stockholders' equity is the average of the beginning and ending stockholders' equity.



Earnings per share. Earnings per share (EPS) represents the net income earned for each share of outstanding common stock. In a simple capital structure, it is calculated by dividing net income by the number of weighted average common shares outstanding.

Price-earnings ratio. The price-earnings ratio (P/E) is quoted in the financial press daily. You simply divide the current share price by the earnings per share. Keep in mind their are two types: Trailing (based upon past earnings)and forward (based upon future earnings)P/Es. A P/E ratio greater than 15 has historically been considered high. But this by itself is a far to simplistic measure. One must consider other variables like revenue and earnings growth, the sector and industry, inflation and the economy.



Solvency ratios are used to measure long-term risk and are of interest to long-term creditors and stockholders.

Debt to total assets ratio. The debt to total assets ratio calculates the percent of assets provided by creditors. It is calculated by dividing total debt by total assets. Total debt is the same as total liabilities.

Business Communications

Communication is one of the basic functions of management in any organization and its importance can hardly be overemphasized. It is a process of transmitting information, ideas, thoughts, opinions and plans between various parts of an organization.

It is not possible to have human relations without communication. However, good and effective communication is required not only for good human relations but also for good and successful business. Effective communication is required at all of an organization.

For manager – employee relations:
Effective communication of information and decision is an essential component for management-employee relations. The manager cannot get the work done from employees unless they are communicated effectively of what he wants to be done? He should also be sure of some basic facts such as how to communicate and what results can be expected from that communication. Most of management problems arise because of lack of effective communication. Chances of misunderstanding and misrepresentation can be minimized with proper communication system.

For motivation and employee morale:
Communication is also a basic tool for motivation, which can improve morale of the employees in an organization. Inappropriate or faulty communication among employees or between manager and his subordinates is the major cause of conflict and low morale at work. Manager should clarify to employees about what is to be done, how well are they doing and what can be done for better performance to improve their motivation. He can prepare a written statement, clearly outlining the relationship between company objectives and personal objectives and integrating the interest of the two.

For increase productivity:
With effective communication, you can maintain a good human relation in the organization and by encouraging ideas or suggestions from employees or workers and implementing them whenever possible, you can also increase production at low cost.

For employees:
It is through the communication that employees submit their work reports, comments, grievances and suggestions to their seniors or management. Organization should have effective and speedy communication policy and procedures to avoid delays, misunderstandings, confusion or distortions of facts and to establish harmony among all the concerned people and departments.

Importance of written communication:
Communication may be made through oral or written. In oral communication, listeners can make out what speakers is trying to say, but in written communication, text matter in the message is a reflection of your thinking. So, written communication or message should be clear, purposeful and concise with correct words, to avoid any misinterpretation of your message. Written communications provides a permanent record for future use and it also gives an opportunity to employees to put up their comments or suggestions in writing


Communication expert Dr. Bill Lampton explains how to adjust your communication style to match the styles of those who differ--so you will communicate more clearly and persuasively.



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