Financial Ratios and Quality Indicators
Monitoring ratios on a regular basis provides insight into how effectively a business is being managed.
Investors/Lenders also evaluate risk by using several sets of ratios; ratios of assets to liabilities, and ratios of lender-investor dollars to owner-investor dollars.
Recognize that ratios are only indicators and that only management can tell the full story about a business. The more adept management is at explaining financial ratios to their Investors/Lenders, the better they will understand your business.
Key Indicators with their definitions, formula and analysis comments are discussed in the following pages:
Page 2 Liquidity: Financial ratios in this category measure the company's
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Formula: Current Assets / Current Liabilities Analysis: • 1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible. • One problem with the current ratio is that it ignores timing of cash received and paid out. For example, if all the bills are due this week, and inventory is the only current asset, but won't be sold until the end of the month, the current ratio tells very little about the company's ability to survive. Quick Ratio Definition: The ratio between all assets quickly convertible into cash and all current liabilities. Specifically excludes inventory. Formula: (Cash + Accounts Receivable) / Current Liabilities Analysis: • Indicates the extent to which you could pay current liabilities without relying on the sale of inventory -- how quickly you can pay your bills. Generally, a ratio of 1:1 is good and indicates you don't have to rely on the sale of inventory to pay the bills. • Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments.
SAFETY Financial ratios in this category are indicators of the businesses' vulnerability to risk. Creditors to