Essential Formulas To Know For A Business Degree Review Final Four Critical Financial Ratios

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Four Critical Financial Ratios

Most startups fail due to financial problems. Potential investors are aware of this.

Just as a ship’s captain posts a watch on deck for signs of danger, an entrepreneur must use a number of financial ratios to determine whether a business is about to take off. These ratios exist to measure and judge the status quo, and we review some key ratios in this document.

Through the use of these tools, suboptimal outcomes can be predicted and perhaps even avoided.

Review of assets and liabilities

Balance sheets classify a company’s assets as current assets or long-term assets. The current assets are expected to provide benefits to the business within the next year. Long-term assets provide benefits for more than one year.

An example of a current asset would be a certificate of deposit with a maturity of six months. A long-lived asset may be a machine that is expected to operate for many years.

A company usually has many assets other than cash on its balance sheet. A company may invest its cash in financial instruments such as money market accounts, certificates of deposit, or U.S. Treasury notes. Because these investments can be quickly converted into cash, common accounting practices treat them as cash equivalents. Cash and cash equivalents are considered current assets.

Similarly, the company has current liabilities and long-term liabilities. Current liabilities are those that are due within the next year. Long-term liabilities are those that will be paid over a period of several years.

Return the property

A common measure of a company is return on assets (ROA). Return on assets helps investors gain insight into how profitably a business is using its assets.

If Company A shows an ROA of 9% while Company B shows an ROA of 23%, we see that Company B is getting more return on its assets. A high ROA may indicate a competitive advantage that makes Company B an attractive investment. Conversely, if you own Company A, you might do well to examine how your competition is producing more profit per dollar of assets.

The ROA formula is:

ROA = Net Income / Average Total Assets

Net income is easily found in a company’s income statement. Average total assets are calculated by adding the value of total assets at the beginning of the year to the value of total assets at the end of the year. Divide that sum by two.

debt ratio

The more debt a business takes on, the more likely the business will be unable to repay that debt. The debt ratio shows the percentage of assets that are financed with liabilities. The debt ratio formula is:

Debt Ratio = Total Liabilities / Total Assets

In spring 2017, Exxon Mobile’s debt ratio was 49% (162,989.00/330,314.00). The other 51% is funded by the company’s shareholders. By comparison, BP’s debt ratio is 64%. If a recession occurs and sales decline, which of these companies is most likely to default on their loans?

Current ratio

A company’s current liabilities are more immediate: liabilities that must be paid within the next year. The current ratio gives investors insight into a company’s ability to pay its near-term obligations. To do this, we use the following formula:

Current Ratio = Total Current Assets / Total Current Liabilities

The higher the ratio, the stronger the fiscal state. Using Outlet Hardwood Flooring Company Lumber Liquidators, we get a current ratio of 8.86. This ratio shows that for every $1.00 of current debt Lumber Liquidators must pay over the next year, it has $8.86 on-hand!

On the other hand, American Airlines’ current ratio at the time of this writing is 0.76, which means that the business has only seventy-six cents for every dollar of debt it will pay over the next year. One business obviously struggles more than another to pay its bills.

Acid-test ratio (i.e. quick ratio)

The acid-test ratio is a more sophisticated version of the current ratio. Total current assets used in the current ratio are not always easily convertible to cash (the company needs to pay off debt quickly). Notably, the list is not included when using the acid-test. The formula is:

Acid-test = cash and equivalents + market. Securities + Act. Receivables / Total Current Liabilities

When we retest Lumber Liquidators with the acid-test ratio, we get a value of 0.22 – showing much weaker than its current ratio. There are many interesting effects here. Lumber Liquidators is a company whose current value comes primarily from its inventory. It has relatively little cash on hand. A shrewd investor can take this information and try to imagine situations in which an inventory-heavy company might suffer and then guess how those episodes might play out.

American Airlines, whose current assets rely less on inventory and more on cash and accounts receivable, has an acid-test ratio of 0.90.

conclusion

Cash is the life blood of a business. Even when sales are good, business owners often look for additional sources of cash to grow the business—either from debt or equity. The information presented on the balance sheet, income statement, and cash flow statement are important to external investors in deciding whether to provide that money to the business. The ratios presented here provide operational insight not only for potential investors but also for current business owners.

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