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 In this section a set of accounting ratios is presented. These ratios can be found in most textbooks on business finance. Such ratios are often divided into the groups shown below; activity ratios, gearing ratios, etc.. Here, their definitions are given along with brief notes about their use.
     The main booklet for this topic covers the points in this and the next tutorials and may be downloaded by clicking on the "other resources" tab above or by clicking here.
     Click on the type of ratio below to go to that group of ratios. To return to the top of this page click on the 'return to top' link that you will find on the left of the screen.

activity    |   gearing    |   liquidity    |   profitability

 
LIQUIDITY RATIOS
 

The current ratio and quick ratio explained below are examples of liquidity ratios. They purport to measure how well a firm is managing its working capital. The general idea is that, if confidence is lost in the firm's ability to continue to trade, the creditors of the firm will ask for their money back more quickly than they otherwise might. For example, the bank might demand a reduction in the overdraft that the firm has and suppliers might refuse to extend credit and demand cash payment when they supply raw materials. In effect this would mean that the current liabilities of the firm would be much reduced.
     In order to meet these demands the firm would have to liquidate some or all of its current assets, that is sell off its stock and ask for the money it was owed by its debtors. In doing so it is unlikely that the firm would be able to liquidate these assets at their full value as expressed in the accounts. For example, the firm would have to reduce the price of its products to sell off the stock quickly and if it demanded repayment from its debtors it might have to accept payment with a discount to compensate for the speed of repayment.
     As a general rule, the greater the current assets compared to the current liabilitites, the safer the firm should be. However, the more powerful the company the less relevant these ratios are. Large firms will not have to repay short-term liabilities quickly, they will have the power to say 'no'. Small firms will not have this power and so, for them, these ratios might be a matter of life or death.

current ratio
 

This ratio gives a measure of the short-term safety of the firm. The current assets are those that could be turned into cash in a short period of time and the current liabilities are those liabilities which might have to be repaid at short notice. Therefore, the higher the level of current assets in relation to current liabilities the less likely it is that the firm will be unable to meet its short-term liabilities.
     It is often argued in the older textbooks that a current ratio of around two is desirable. In this way the firm could liquidate its stock by selling it at half price, recall the debts it is owed at short notice by allowing its debtors to pay half of what was owed and still have enough money to pay off its current liabilities in full. However, most large firms these days have current ratios which are significanltly lower than this. For example, the big retailers might well have current ratios of around one half.
     It should be noted that this ratio might act in ways which seem to contradict the textbooks. For example, imagine that a firm is getting into trouble. If its suppliers know this they might ask for payment more quickly. This would reduce the creditors or accounts payable in the balance sheet. Also, the firm could be having difficulty selling its products so stocks might well increase. In this case, the firm's current liabilities will be falling and its current assets rising. So the current ratio would be increasing even though the firm is becoming weaker and more likely to fail.

quick ratio
 

A criticism of the current ratio is that stocks might be difficult to turn into cash quickly. For example, some of the stocks might be in the form of work-in-progress which takes time to turn into a final product. So these elements could not be sold at short notice. Therefore, it is suggested that stocks should be removed from the current asset figure in the consideration of short-term liquidity of the firm. The result is the ratio above.
     The quick ratio is very similar to the current ratio, the only difference being the removal of stocks.
     The quick ratio is also known as the acid test ratio. Again it is often suggested in the older textbooks that a figure of around one is ideal for this ratio. Manufacturing firms, which would have relatively illiquid stocks and work-in-progress, might have quick ratios of around this figure. Retailers will often have ratios which are considerably lower.

 
GEARING RATIOS
 

Gearing ratios, which in American parlance would be referred to as leverage ratios, show the relative amounts of capital provided by shareholders (equity) and those lending money to the firm in the form of credit of one type or another (debt).
     There are a number of different definitions of gearing ratios, some of which are given below. If the term gearing ratio is used in any financial discussion it is not immediately clear which ratio is being referred to. However, it is always true to say that a firm with a high gearing ratio, however defined, will be a firm which has a high level of debt and a relatively low level of equity. Conversely, if a firm has low gearing it will have financed its assets mainly from equity and will only have a little debt.
     As debt is usually cheaper than equity, it is profitable to have some debt in the firm as this means that the funds required can be raised a little more cheaply. Therefore, low gearing ratios could mean that the firm is paying too much for the money it is raising to finance its assets. Maybe it should be borrowing some 'cheap' debt to purchase assets rather than use more expensive equity. However, high gearing ratios mean that the firm has a lot of debt. In this case, if interest rates rise and profits fall the firm might not make enough money to pay its interest payments. Thus, high gearing is seen as being somewhat risky. Also, the risk of defaulting on interest payments increases as gearing rises. So management time is taken up in financing decisions and, in extreme cases, negotiating the deferral of interest payments rather than in the management of the productive activities of the firm.

debt to equity ratio
 

In this ratio the numerator contains every liability which is not equity. That is to say it will include current liabilities and long-term debt. The denominator includes the share capital and the reserves accumulated under retained earnings. Therefore, if half of the assets are funded by equity and half by debt, this ratio will equal one.
     In some definitions of this formula the numerator contains only long-term debt, current liabilities being excluded. In either case, the higher the ratio the higher the level of debt compared to equity.

debt ratio
 

This is very similar to the debt to equity ratio except that the numerator is total liabilities rather than just equity. Of course, the numerator could equally be total assets, the result would be the same. This ratio shows the proportion of total liabilities that comprises debt. Similarly, it shows the proportion of total assets that are funded by debt rather than equity. In this case, if half the assets in the firm are funded by equity and half by debt the ratio will be one. The reason is simply that the denominator, total liabilities, will be half equity and half debt. Again, the higher the ratio the higher the level of debt compared to equity.
     This ratio and the debt to equity ratio are obviously very closely related. If TD is total debt, TE total equity, TA total assets and TL total liabilities, the following is true.

     Consider a firm with total assets of one million, a quarter of which are funded by debt and three-quarters by equity. It follows that total liabilities will be one million, debt will be 250,000 and equity 750,000. The gearing ratio here will be equal to 250,000/1,000,000 or 25%. The debt to equity ratio above will be equal to 250,000/750,000 or one third.

times interest earned
 

The problem associated with high gearing is that the firm might not be able to meet its interest payments if interest rates rise and profits fall. In times of recession a firm with a low gearing ratio will merely declare a lower dividend and wait for the economy to recover. A firm with a high gearing ratio, even if it pays no dividends, might not be generating enough cash to pay the interest on its debt. In this case the firm could be forced into liquidation by its creditors.
     To measure this riskiness the times interest earned ratio (sometimes referred to as interest cover) is used. The higher the ratio the more times the interest payments are covered by the firm's profit.
     For example, if the firm is making £100 profit before tax and interest and is paying £10 as interest its times interest earned ratio would be ten. This means that it is earning ten times the interest payments it has to make. In this case interest rates could double so that interest payments rise to £20 and profits fall to 20 per cent of their current level (i.e. to £20) and the firm could still meet its interest payments. On the other hand if the times interest earned ratio were only two, so that interest payments were, say, £50, then if interest rates doubled the firm would have no profits left after paying its interest payments. So a slight fall in earnings would be disastrous.

 
ACTIVITY RATIOS
 

Activity ratios show the ability of the firm to manage its basic activities efficiently. They tend to relate assets to sales in some way and so, in general, the higher the ratio the more sales are being generated by the firm for the level of assets. As assets have to be funded by some form of liability, e.g. debt, and debt has to be paid for it follows that the more sales that can be generated from a given level of assets, the greater the profitability of the firm. Therefore, as a general rule, the higher these ratios the better, although there are exceptions to this.

stock turnover ratio
 

This is a very widely used ratio, and in American terminology it would be referred to as the inventory turnover ratio and inventories would appear in the denominator of the equation. The numerator, COGS, refers to the cost of goods sold which is sometimes entered in the accounts under the heading cost of sales.
     This ratio shows the efficiency with which a firm manages it stock levels. Taking a simple set of numbers, imagine that the COGS is £1000 and the level of stock is £100, the stock turnover ratio as defined above will be ten times. What this suggests is that the stock is turned over ten times in the year. Taking the simple example of a retail firm, it is easy to imagine the stock being sold and replenished, then sold and replenished again. The average stock level of £100 would be sold, or turned over, ten times in the year.
     There is a small point of confusion here. Imagine a firm runs its stock down smoothly. If the average stock level is 100 it follows that it buys in 200 and runs this down to zero in the course of trading. In this case the average stock level will be 100, half the time the stock is above this level and half the time it is below it. Thus the firm will purchase stock five times a year. The stock turnover ratio refers to the average stock level and so returns a figure of ten.
     In some texts, sales or turnover are given as the numerator rather than COGS. The firm's sales or turnover figure should be greater than the cost of goods sold, of course, as a profit margin would be added. If, for example, the profit margin were 10% the sales figure would be £1,100, i.e. ten percent higher than the COGS figure. However, it should be clear that the higher the stock turnover ratio the higher will be the level of COGS and, therefore, the higher the level of sales, for a given level of stock. In general, firms will attempt to increase this ratio. However, there is another side to the coin. A high stock turnover ratio implies a low level of stocks and this increases the possibility of a 'stock out', that is a situation where sales are missed because the items are not in stock or cannot be produced rapidly. In this case, a high stock turnover ratio might be detrimental to sales and profits.
     The numerator of the equation is sometimes given as the average stock level which is usually estimated as the average of the stock at the beginning of the year and the stock at the end of the year. If the stock level has not changed very much over the year this formulation will be very similar to that given in the formula above. However, if a lot of stock has just arrived in anticipation of greater sales in the future, the level of stock in the current accounts will now be greater than the average over the year. The stock turnover ratio using the formula given here will appear to be smaller than it actually is.
     Recently a large number of companies have been introducing so-called just-in-time systems whereby stock and raw materials are delivered to the factory just before they are needed. This will increase the stock turnover ratio by reducing stock levels.

fixed asset turnover ratio
 

Although this is often referred to as a turnover ratio, it makes little sense to talk about 'turning over' fixed assets. However, the ratio is a very useful one for measuring the efficiency of the firm. The higher the level of sales generated by each 'unit' of fixed assets the more efficient the firm might be thought to be.
     In interpreting this ratio a little care is needed. The figure given for the ratio depends critically on the value of the fixed assets found in the balance sheet. For example, consider two identical firms except that one has purchased the land on which its factory stands recently and one purchased it a long time ago. As the land will be entered in the balance sheet at cost, one firm will have a lower figure in its accounts than the other. The one which purchased the land a long time ago will probably have paid less for it. Therefore, it will have a lower level of fixed assets and a higher fixed asset turnover ratio. However, this is no justification for arguing that it is more efficient.
     Often, these ratios are quoted as being two times or 4.5 times, rather than just simply as two or 4.5. This recalls the idea of turning over stock two times a year, etc. but here the word 'times' has little significance.

total asset turnover ratio
 

This is a very similar ratio to the fixed asset turnover except that total assets are used in the denominator. As total assets are equal to fixed assets plus current assets the denominator of the fraction here will be greater and the corresponding ratio will be lower than was the case with the fixed asset turnover ratio above. Again, like the fixed asset turnover ratio, care is needed in interpreting the valuation of fixed assets in the accounts.

days sales outstanding
 

This ratio, which is also referred to debtor days, measures the length of time required for the firm to get the money for the goods that it sells. The longer this period is the longer the firm has to wait. This might be a good thing if the firm is selling on credit. However, it might also be a sign of slack management with bills not being followed up quickly and people paying the firm very late.
     To understand the ratio imagine that the firm sells £100s worth of goods a day. If customers are given ten days to pay, and all of them avail themselves of this facility, it follows that the firm will have debtors of £1,000. At any moment in time, there will ten lots of days sales owed to the firm, i.e. the debtors will be ten times the average daily sales.
     The denominator of the fraction is sometimes given as credit sales rather than just sales. However, if you are working with published accounts, rather than within the firm, it is unlikely that figures for credit sales will be available. In this case there is no alternative but use the figure for total sales or turnover.
     Sometimes the formula is written out as follows.

     This is the same formula as the first one for days sales outstanding, the only difference being the way in which average daily sales are presented. Multiplying by 360 and dividing by total annual sales is the same as dividing the daily sales. Note that it is often assumed in this types of analysis that there are 360 trading days in a year. Sometimes the number 365 will be used. The difference in the final figures arrived at is not important.

 
PROFITABILITY RATIOS
 

As most companies' avowed aim is to make profits it follows that the most important ratios to analyse are the profitability ones. However, these ratios tend to be less diagnostic than those looked at earlier. The reason is that, if a firm is making poor profits and has low profitability, the reason will probably lie in areas such as its operating methods, and this will show up in ratios such as the turnover ratios defined above. Thus, profitability ratios give the overall performance of the firm but the other ratios described above will offer a more detailed look at the individual elements of a firm's activities. For a discussion of how profitability ratios can be broken down to show the sources of profit see tutorial four.
     As with many ratios, different sources give slightly different definitions. For example, sometimes net profit is used and sometimes gross profit is employed in the calculation of the figures.
      Importantly, these ratios will depend on the competitive environment of the firm. If the firm is in a highly competitive market its profitability ratios will be relatively low. On the other hand, if the firm is a monopoly or is selling a unique product or serving a niche market, its profitability ratios will be less affected by competitive pressures and so ought to be relatively higher.

net profit margin
 

This ratio shows the proportion of the sales revenue that is profit. If the firm makes sales of £100 and of this £90 is accounted for by the costs of production, it follows that the profit margin will be 10%. It might seem that the term 'net' would mean that the profit after tax should be used. However, here it means the profit after the costs of administration and sales have been taken into account. There is a gross profit margin that refers to the gross profit made by the firm. This is equal to the turnover minus the cost of goods sold where the costs of administration and distribution have not been subtracted.
     It might seem that the higher the ratio the better, but this need not necessarily be the case. For example, a firm that is introducing a new product and attempting to gain market share might well place a low price on the product in order to sell as much as possible. In this case, the profit margin, in the short-term at least, will be fairly low. Also, the profit margin will depend on the nature of the market niche in which the firm is operating in. For example, a firm at the lower end of the market might be selling a relatively low quality product with a low profit margin whereas a firm at the top end of the market will be selling fewer units but at a higher price and with a higher profit margin.

return on total assets
 

This ratio shows the return that is made on all of the assets that the firm is using. The higher the ratio the better, bearing in mind the comments made concerning the net profit margin above. Also, the valuation problems associated with the asset figures in the balance sheet should be borne in mind.

return on capital employed
 

Here, the effectiveness of the assets that are financed by the long-term lenders and shareholders is being assessed. Therefore, the denominator consists of the long-term capital. The numerator is operating profit as this shows the profit before the interest payments and tax are paid. Again, the higher this ratio the better, but the points made concerning the net profit margin should be borne in mind.

return on shareholders' funds
 

This ratio shows the profits to which the shareholders are entitled (the numerator) divided by the total amount of money which the shareholders have contributed to the firm (the denominator). This looks at the firm's performance purely from the shareholders' point of view. Note that the figures here are book values, that is they are the figures for equity which would be found in the accounts. These figures need not have any close relationship with the market value of the shares of the company. If the firm is doing very well its share price will be high and so its actual equity value in the market will be higher than that in the accounts.
     For example, if a firm has issued share capital which has a nominal value of £1,000 and it has retained earnings also of £1,000 the equity figure in the accounts will be £2,000. However, if the firm is doing very well and has good prospects the value of its shares on the stock exchange might be, say, £8,000. Thus, anyone buying the shares would be entitled to the earnings but only after having paid four times the book value of the equity. Thus, the actual return on shareholders' funds would be one quarter that given by the equation above. Conversely, if the firm is doing badly, the market value of its equity might only be £1,000. In this case, anyone buying the shares in the company would only have to part with a sum of money equal to half the book value. The ROSF in this case would be twice that given in the equation.
     This ratio is also known as the return on equity or ROE.

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