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Ratios to measure Return on Investments
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Return on Equity
Measures the return on the investment made by the business’ owners
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Ratio
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Example*
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Net income (from Income Statement)
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465,000
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= 9.2%
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Average stockholders’ equity (Balance Sheet)
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(5,239,000 + 4,860,000) / 2
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Return on Assets
Measures return on the gross investment in the business, including that finance by the owners, as well
as that finance by creditors. The relationship between the returns on assets and on equity is indicative of the effect of the business’ financial leverage. If the leverage is positive, the return on equity will be
greater than the return on assets.
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Ratio
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Example*
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Net income (Income Statement)
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465,000
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= 4.1%
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Average total assets (Balance Sheet)
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(11,636,000 + 11,004,000) / 2
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Ratios to measure Safety and Liquidity
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Net working capital
Indicates the business’ ability to meet short-term obligations, reporting the excess of current
assets over current liabilities.
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Ratio
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Example*
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Current assets (Balance Sheet) -
Current Liabilities
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2,155,000 - 1,924,000
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= 231,000
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Current ratio
Also indicates the ability to pay current liabilities as they mature, providing the ratio of current assets
to current liabilities. A ratio of 1:1 or greater corresponds to positive net working capital.
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Ratio
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Example
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Current assets (Balance Sheet)
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2,155,000
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= 1.12:1
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Current Liabilities (Balance Sheet
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1,924,000
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Debt to Equity
Indicates the balance between total equity ownership (common and preferred stockholders) and long-term
debt. The greater the percentage, the more “leveraged” is the company.
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Ratio
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Example*
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Long-term debt (Balance Sheet)
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2,302,000
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= 30.5%
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Capitalization (Long-term debt plus Stockholders’ equity) (Balance Sheet)
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2,302,000 + 5,239,000
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Times interest earned
Measures the ability of a company to cover the payment of interest to borrowers.
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Ratio
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Example*
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Income before interest and taxes (Income Statement)
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840,000 + 242,000
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= 4.5 times
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Interest expense (Income Statement)
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242,000
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Debt service ratio
This ratio is an indicator of the company’s ability to pay both the interest and the current principal
installments on its outstanding debt, and suggests the degree of safety for creditors concerning currently due debt service obligations.
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Ratio
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Example*
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Income before interest and taxes (Income Statement)
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840,000 + 242,000
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= 1.9 times
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Interest expense plus amounts of scheduled debt repayments (Income Statement, and Statement of Cash Flows)
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242,000 + 324,000
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Ratios to measure Operating Efficiency
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Collection period
Measures the number of days’ sales that are uncollected in average accounts receivable, providing an
idea of how successful the firm is in collecting its customer debt.
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Ratio
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Example*
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Average accounts receivable (Balance Sheet)
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(1,178,000 + 1,175,000) / 2
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= 53.4 days
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Average daily sales (Income Statement)
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7,934,000 / 360
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Receivable turnover ratio
An alternative, but equivalent, measure of the efficiency of the company’s receivables
collection efforts. If the company also makes sales for cash, “total credit sales” should be substituted for “total sales.”
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Ratio
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Example*
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Total sales (Income Statement
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7,934,000
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= 6.7 times
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Average accounts receivable (Balance Sheet)
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(1,178,000 + 1,175,000) / 2
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Number of days’ sales in inventory
An indicator of the amount of inventory maintained relative to the company’s sales (as
measured by the cost of goods sold).
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Ratio
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Example*
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Average inventory (Balance Sheet)
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(458,000 + 424,000) / 2
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= 23.3 days
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Average daily cost of sales (Income Statement)
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6,816,000 / 360
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Inventory turnover ratio
An alternative measure of how quickly inventory is sold.
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Ratio
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Example*
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Cost of goods sold (Income Statement)
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6,816,000
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= 15.5 times
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Average inventory (Balance Sheet)
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(458,000 + 424,000) / 2
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* Figures used in ratio examples are from the financial statement examples:
Balance Sheet, Income Statement, and Statement of Cash Flows.
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