Financial Ratios

Liquidity ratios are essential financial metrics used to assess a business’s ability to meet its short term financial obligations promptly. These ratios are derived from information found in the balance sheet and cash flow statement, focusing on the business’s working capital performance.  

Working capital represents the funds available to cover current and short term liabilities, emphasising the importance of liquidity in managing day to day financial operations. 

AASB 107 Statement of Cash Flows is instrumental in managing working capital and short term funding needs by detailing cash inflows and outflows, which are essential for liquidity ratio analysis, including current and quick ratios 

By evaluating liquidity ratios, a business can gauge its capacity to fulfil short term debts promptly. Unlike solvency ratios, which assess the business’s ability to settle all debts, liquidity ratios specifically analyse the business’s ability to address immediate financial obligations. Therefore, they serve as vital indicators of the business’s financial health, providing insights into its liquidity position. 

Liquidity ratios act as a warning system for a business, signalling when it may be facing a shortage of available funds. These ratios quantify the level of liquidity, including cash and easily convertible assets, available to cover debts. They offer a broad overview of the business’s financial well being, highlighting potential liquidity challenges or strengths.  

Current Ratio 

The Current Ratio is a financial metric used to assess a business’s ability to meet its short term financial obligations with its short term assets. It measures the proportion of current assets available to cover current liabilities, reflecting the business’s liquidity position. It is also called Working Capital Ratio. 

Calculation: The Current Ratio is calculated by dividing the business’s current assets by its current liabilities. The formulae is as follows:  

Current Ratio = Current Assets / Current Liabilities 

Interpretation: 

The Current Ratio provides insights into the business’s liquidity and its ability to repay short term debts. A ratio above 1 indicates that the business has more current assets than current liabilities, suggesting sufficient liquidity to meet its obligations. A ratio of 2 or higher is often considered favourable, indicating a strong liquidity position.  

Conversely, a ratio below 1 suggests that the business may struggle to settle its short term debts if they were due immediately, potentially facing cash flow challenges.  

It’s essential to consider industry norms and the business’s specific circumstances when interpreting the Current Ratio, as acceptable ratios may vary across different sectors.  

Additionally, while a higher Current Ratio generally indicates better liquidity, excessively high ratios may imply inefficient asset management, such as holding excessive levels of inventory. 

Quick Ratio (Acid Test Ratio) 

The Quick Ratio, also known as the Acid Test Ratio, is a financial metric used to evaluate a business’s ability to meet its short term financial obligations using its most liquid assets. Unlike the Current Ratio, which considers all current assets, the Quick Ratio focuses only on the most liquid assets that can be readily converted into cash to settle short term liabilities. 

Calculation: The Quick Ratio is calculated by subtracting less liquid current assets, such as prepaid expenses and inventories, from total current assets, and then dividing the result by current liabilities. The formulae is as follows: 

Quick ratio = Current assets – Inventory – Prepaid Expenses/Current Liabilities 

Interpretation 

The Quick Ratio provides a more stringent assessment of a business’s ability to cover its short term obligations compared to the Current Ratio. By focusing on highly liquid assets such as cash, cash equivalents, short term investments, and accounts receivable, the Quick Ratio offers insights into the business’s immediate debt paying ability. 

A Quick Ratio of 1:1 is generally considered ideal, indicating that the business has enough liquid assets to cover its current liabilities. A ratio lower than 1 may suggest that the business may struggle to meet its short term obligations using only its most liquid assets.  

However, it’s essential to compare the Quick Ratio with the Current Ratio to gain a comprehensive understanding of the business’s liquidity position. If the Current Ratio is significantly higher than the Quick Ratio, it may indicate that the business’s liquidity heavily relies on less liquid assets like inventory, which may pose risks in meeting short term payments. 

Cash Ratio 

The Cash Ratio offers a stringent assessment of the business’s ability to settle short term debts using only its most liquid assets, excluding less liquid assets like inventory. By considering only cash and cash equivalents, which are highly liquid and readily available, the Cash Ratio provides insights into the business’s immediate debt paying ability. 

Calculation: The Cash Ratio is calculated by dividing the business’s cash and cash equivalents by its current liabilities. The formulae is as follows: 

Cash Ratio = Cash & Cash Equivalent / Current Liabilities 

Interpretation 

A higher Cash Ratio indicates a stronger liquidity position, suggesting that the business has sufficient liquid assets to cover its short term liabilities. On the other hand, a lower Cash Ratio may indicate potential liquidity challenges, indicating that the business may struggle to meet its immediate financial obligations using only its cash and cash equivalents. 

The Cash Ratio is particularly useful during periods of financial distress or uncertainty, as it focuses on the most liquid assets that are readily available for meeting short term obligations.  

Operating Cash Flow Ratio 

The Operating Cash Flow Ratio evaluates the business’s ability to generate sufficient cash from its core operational activities to cover its short term debt obligations. 

Calculation: The Operating Cash Flow Ratio is calculated by dividing the cash flow from operations by the business’s current liabilities. The formulae is as follows:  

Operating cash flow ratio = cash flow from operations /current liabilities 

Interpretation 

Cash Flow from Operations (CFO): This represents the cash generated or used by a business’s core operating activities during a specific period. It includes cash received from customers, cash paid to suppliers and employees, and other operating expenses. CFO reflects the business’s ability to generate cash from its day to day business operations. 

A ratio less than 1 indicates that the business may not be generating enough cash to meet its current liabilities. In such cases, the business may face challenges in paying off its short term debts using the cash generated from operations alone, potentially leading to liquidity issues. 

When the Operating Cash Flow Ratio falls below 1, it suggests that the business may struggle to sustain its operations in the short run, as it may not have enough cash flow from operations to meet its immediate financial obligations.  

This situation could indicate financial distress and may require the business to consider measures to improve its cash flow generation or manage its current liabilities more effectively. 

Operational efficiency ratios, also known as activity ratios, assess a business’s effectiveness in utilising its resources to generate sales and income. These ratios analyse the business’s ability to manage its assets, working capital, and core business processes efficiently, providing insights into its operational performance and ability to create shareholder value. 

Asset Turnover Ratio 

The Asset Turnover Ratio provides insight into how efficiently a business utilises its assets to generate sales revenue. It measures the relationship between the business’s net sales and its average total assets over a specific period. 

Calculation: The Asset Turnover Ratio is calculated by dividing the business’s net sales by its average total assets. The formulae is as follows: 

Asset turnover ratio = net sales / average total assets 

Interpretation 

The Asset Turnover Ratio provides insight into the business’s efficiency in converting its asset base into sales revenue. A higher ratio indicates that the business generates more sales revenue per dollar of assets, suggesting efficient asset utilisation and effective business operations.  

Alternatively, a lower ratio suggests inefficiency in asset utilisation, indicating that the business may not be effectively leveraging its asset base to generate revenue. 

Inventory Turnover Ratio 

Inventory turnover ratio is used to evaluate the efficiency with which a business manages its inventory by measuring how quickly inventory is sold and replaced within a specific period, usually a financial year. It reflects the relationship between the cost of goods sold (COGS) and the average inventory level during the same period. 

AASB 102 Inventories and AASB 116 Property, Plant, and Equipment provide essential guidance on measuring and reporting costs associated with inventories and fixed assets. These standards impact cost of goods sold and depreciation expense calculations, which are crucial for evaluating operational efficiency 

Calculation: Inventory turnover can be calculated using various formulaes, but the fundamental principle remains consistent: dividing the cost of goods sold (COGS) by the average inventory. 

The formulae can be expressed as follows: 

Inventory Turnover = Cost of Goods Sold / Average Inventory 

Cost of Goods Sold (COGS): This is the direct cost incurred by a business in producing goods or services that have been sold during a particular period. It includes expenses such as raw materials, labour, and manufacturing overhead. COGS does not include indirect expenses like distribution costs or marketing expenses. 

Average Inventory: This is the average value of inventory held by a business during a specific period, typically calculated as the average of the beginning and ending inventory balances. It reflects the level of inventory maintained by the business over the period and is used to smooth out any fluctuations in inventory levels. 

The inventory turnover ratio indicates how efficiently a business is managing its inventory and selling its products. A higher inventory turnover ratio typically suggests better performance, as it implies that inventory is being sold and replaced quickly. This may indicate strong sales performance, effective inventory management, and responsiveness to changes in market demand.  

Furthermore, it shows a reduced risk of holding onto damaged or obsolete stock, as inventory is being sold off quickly, minimising the likelihood of inventory write offs or losses. 

Conversely, a lower inventory turnover ratio may indicate inefficiencies in inventory management or weak sales performance. It could suggest overstocking, obsolete inventory, or challenges in meeting customer demand. 

Accounts Payable Turnover Ratio 

The accounts payable turnover ratio evaluates how fast a business settles its obligations to creditors and suppliers. It indicates the speed at which the business pays off its accounts payable, reflecting its management of supplier payments. 

Calculation: The accounts payable turnover ratio is calculated by dividing the net credit purchases by the average accounts payable. 

The formulae can be expressed as follows: 

Accounts Payable Turnover Ratio = Net Credit Purchases / Average Accounts Payable 

To calculate the net credit purchases, one subtracts the beginning accounts payable balance from the ending accounts payable balance and adds any cash payments made to suppliers during the period. 

The average accounts payable is determined by averaging the beginning and ending accounts payable balances. 

Interpretation 

A higher accounts payable turnover ratio indicates that the business is paying off its suppliers more frequently within the given period. This may suggest efficient invoice management and good relationships with suppliers, as the business is able to meet its payment obligations promptly or even before the due date.  

It also signifies effective cash flow management, as the business is not holding onto excessive amounts of accounts payable for an extended period. 

On the other hand, a lower accounts payable turnover ratio may suggest inefficiencies in payment processes or strained relationships with suppliers. It could indicate delays in settling accounts payable or difficulties in managing cash flow effectively. 

Receivables Turnover Ratio 

The receivables turnover ratio is a financial metric that assesses how efficiently a business converts its credit sales to cash by analysing its accounts receivable. Accounts receivable represent the amount owed to the business by its customers for goods or services sold on credit. 

Calculation: To calculate the receivables turnover ratio, one divides the net credit sales by the average accounts receivable. 

The formulae is represented as: 

Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable 

Net credit sales refer to the total sales made on credit, excluding cash sales and any returns or allowances. Average accounts receivable is computed by averaging the beginning and ending balances of accounts receivable over a specific period. 

Interpretation 

A higher receivables turnover ratio indicates that the business is efficiently collecting payments from its customers. This suggests effective credit management and timely conversion of accounts receivable into cash. It signifies that customers are paying their dues promptly, contributing to healthy cash flow. 

A lower receivables turnover ratio may indicate issues with revenue collection. It could suggest slow paying customers or ineffective credit management practises. A low ratio implies that the business is taking longer to convert its credit sales into cash, potentially leading to cash flow challenges and increased risk of bad debts. 

Monitoring the receivables turnover ratio helps businesses evaluate the effectiveness of their credit policies and collection efforts. It provides insights into how efficiently the business manages its accounts receivable and its overall financial health. 

Average Collection Period 

The average collection period shows the time it takes for customers to settle their outstanding bills. It provides insight into the efficiency of the business’s accounts receivable management by indicating how long it typically takes to collect payments from customers. 

Calculation 

To calculate the average collection period for a given year, the business utilises the following formulae: 

Average Collection Period = (365 * Accounts Receivable Turnover Ratio) / Net Credit Sales 

Net Credit Sales: This represents the total sales made on credit, excluding cash sales, sales returns, and sales allowances. It reflects the revenue generated by the business from credit transactions. 

To calculate the net credit sales, the business applies the formulae:  

Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances 

Interpretation 

A shorter average collection period indicates that customers are paying their bills more promptly, resulting in healthier cash flow and reduced risk of bad debts. 

A longer average collection period suggests delays in collecting payments from customers, which could strain cash flow and increase the risk of overdue accounts. It may indicate issues such as ineffective credit policies, slow paying customers, or inadequate collection procedures. 

Leverage ratios are utilised by entities to evaluate the level of debt they have taken on, both in the short term and long term, to finance their operations. These ratios offer insights into the business’s debt levels. 

The leverage ratio typically compares the amount of debt a business has to either its total assets or its equity, as indicated in its financial statements such as the balance sheet or income statement. By using this ratio, investors can gain an understanding of the business’s financial structure, particularly its reliance on debt for financing.  

Additionally, lenders can use leverage ratios to assess the business’s ability to repay loans. Leverage ratios assist in assessing the business’s debt burden and its capacity to manage it effectively. 

Debt Ratio 

This ratio compares the total debt of a business, including both short term and long term debt, to its total assets. It provides insight into how much of the business’s assets are financed by debt.  

A higher debt ratio indicates that a larger portion of the business’s assets is funded by debt, suggesting higher financial risk, whereas a lower debt ratio suggests that the business relies less on debt financing and may have more financial stability. The formulae for the debt ratio is: 

Debt Ratio = Total Debt / Total Assets 

Debt to Equity Ratio 

This ratio measures the proportion of debt financing relative to equity financing in the business’s capital structure. It compares the total debt to the total equity, providing an indication of the business’s financial leverage.  

A higher debt to equity ratio suggests that the business relies more on debt financing, potentially increasing financial risk but also potentially boosting returns on equity. The formulae for the debt to equity ratio is: 

Debt to Equity Ratio = Total Debt / Total Equity 

Interest Coverage Ratio 

This ratio assesses the business’s ability to cover its interest expenses with its earnings before interest and taxes (EBIT). It indicates the business’s capacity to meet its interest obligations from its operating income.  

A higher interest coverage ratio implies that the business generates sufficient earnings to comfortably cover its interest payments, indicating financial stability. On the contrary, a lower ratio may suggest potential financial strain if the business struggles to cover its interest expenses. The formulae for the interest coverage ratio is: 

Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expenses 

These ratios provide valuable insights into a business’s financial health, risk profile, and ability to meet its debt obligations. By analysing these ratios, stakeholders can make informed decisions regarding investment, lending, and overall financial management strategies. 

Market value ratios are useful for assessing the value of a business. These ratios are commonly used by external stakeholders such as market analysts and investors to evaluate the business’s worth, but internal management also utilises them to monitor the value per share of the business. 

For estimating market value and conducting competitor analysis, AASB 101 ensures that financial statements provide a comprehensive and comparable set of financial data, facilitating the calculation of market to book ratios and other valuation metrics. 

Earnings Per Share Ratio 

The earnings per share (EPS) ratio indicates how much profit can be attributed to each share of the business’s stock. It’s calculated by dividing the business’s net income (total profit after deducting expenses, interest, and taxes) minus any preferred dividends by the average number of outstanding common shares. This ratio helps investors understand the profitability per share. 

When external stakeholders assess financing options or make investment decisions, AASB 133 Earnings per Share provides a basis for calculating earnings per share (EPS), a key ratio for investors. 

The formulae to calculate EPS is as follows: 

EPS = (Net Income – Preferred Dividends) / End of Period Common Shares Outstanding 

Price Earnings Ratio 

The price earnings (P/E) ratio reveals the price investors are willing to pay for each dollar of the business’s earnings. It’s a fundamental ratio that reflects how the market values the business’s shares. A higher P/E ratio indicates that investors anticipate higher future growth and are willing to pay a premium for the business’s stock.  

Alternatively, a lower P/E ratio suggests either undervaluation of the stock or lower growth expectations. The formulae to calculate Price Earning Ratio is as follows: 

P/E Ratio = Share Price / Earnings per Share 

The Book Value Per Share Ratio  

It is a financial measure used to assess the accounting value of a business’s common equity on a per share basis. It reflects the value of assets minus liabilities attributed to common shareholders, divided by the total number of outstanding common shares.  

Also known as net asset value per share or shareholders’ equity per share, this ratio helps investors understand the intrinsic value of each share. To calculate book value per share ratio, the formulae is as follows: 

Book Value Per Share Ratio = (Total Equity – Preferred Equity) / Total Shares Outstanding 

The Dividend Yield Ratio  

indicates the annual dividend income an investor can expect from a business’s stocks relative to its current market price. It is particularly important for investors seeking regular income from their investments.  

The ratio is calculated by dividing the dividend per share by the share price, representing the value of dividends received for every share owned when the business pays dividends to shareholders. 

Dividend Yield Ratio = Dividend Per Share / Share Price 

All these market value ratios offer insights into the financial health and attractiveness of a business’s stock for investors, helping them make informed investment decisions based on dividend income potential and underlying asset value per share. 

Accuracy in financial data is paramount when computing ratios. Using precise and reliable financial figures ensures the credibility and validity of the analysis. Errors or inaccuracies in data inputs can lead to misleading conclusions and incorrect assessments of the business’s financial health.  

Therefore, thorough verification and validation of financial information before performing ratio analysis are essential to ensure accurate results. 

Instead of relying solely on traditional benchmarks, such as industry averages or competitors’ performance, this practise encourages entities to explore innovative benchmarking methods. Creative benchmarks could include unconventional yet relevant metrics or performance indicators that offer unique insights into the business’s performance.  

By leveraging creative benchmarks, entities can gain a more comprehensive understanding of their competitive position and identify areas for improvement that may not be apparent through conventional benchmarking alone. 

Proper interpretation of financial ratios is crucial for making informed business decisions. This involves understanding the meaning and implications of each ratio in the context of the business’s specific circumstances and industry dynamics.  

For example, a high debt to equity ratio may indicate a higher risk of financial distress, but if the business operates in a capital intensive industry where high debt levels are common, this ratio may not necessarily be a cause for concern.  

Therefore, interpreting ratios requires considering various factors and using sound judgement to draw meaningful conclusions. 

Incorporating balance sheet averages, such as the average values of balance sheet items over a specific period, can provide additional insights during ratio analysis. By using averages, entities can smooth out fluctuations in financial data and obtain a more stable and representative picture of their financial position and performance.  

This practise is particularly useful when analysing ratios that are sensitive to short term fluctuations, such as liquidity ratios. By calculating ratios based on sheet averages, entities can mitigate the impact of temporary fluctuations and obtain more reliable insights into their overall financial health. 

To gain a holistic understanding of the business’s performance, it’s essential to conduct a comprehensive analysis that incorporates financial data from various sources, including income statements, balance sheets, and cash flow statements.  

Each of these financial statements provides unique insights into different aspects of the business’s operations, financial position, and cash flow dynamics. By integrating data from all three statements, entities can identify interrelationships between different financial metrics and gain a deeper understanding of the underlying drivers of their financial performance.  

This comprehensive approach enables entities to make more informed decisions that are based on a thorough understanding of their overall financial situation and performance trajectory. 

Making informed decisions for the business can be challenging amidst the abundance of available data. Ratio analysis enables entities to compare various metrics, providing deeper insights into performance relative to competitors and internal objectives over time.