28 Understanding the Numbers
USING FINANCIAL RATIOS
Some important points to keep in mind when using financial ratios are:
- Whereas all balance sheet numbers are end-of-period numbers, all in-
come statement numbers relate to the entire period. For example, when
calculating the ratio for Accounts Receivable Turnover, we use a numera-
tor of Credit Sales, which is an entire-period number from the income
statement, and a denominator of Accounts Receivable, which is an end-of-
period number from the balance sheet. To make this an apples-to-apples
ratio, the Accounts Receivable can be represented by an average of the
beginning-of-year and end-of-year figures for Accounts Receivable. This
average is closer to a mid-year estimate of Accounts Receivable and there-
fore is more comparable to the entire-period numerator, Credit Sales. Be-
cause using averages of the beginning-of-year and end-of-year figures for
balance sheet numbers helps to make ratios more of an apples-to-apples
EXHIBIT 1.1 Summary of main financial ratios.
Ratio Numerator DenominatorShor t-Term Liquidity
Current ratio Current assets Current liabilities
Quick ratio (acid test) Current assets Current liabilities
(excluding inventory)
Receivables turnover Credit sales Accounts receivable
Inventory turnover Cost of sales Inventory
Payables turnover Cost of sales Accounts payable
Long-Term Solvency
Interest coverage EBIT Interest on L / T debt
Debt to capital Long-term debt L / T debt+equity
Profitability on Sales
Gross profit ratio Gross profit Sales
Operating expense ratio Operating expenses Sales
SG&A expense ratio SG&A expenses Sales
EBIT ratio EBIT Sales
Pretax income ratio Pretax income Sales
Net income ratio Net income Sales
Profitability on Investment
Return on total assets:
Before tax EBIT Total assetsa
After tax EBIT times (1-tax rate) Total assetsa
Return on equity Net income: Commonb Common equity
aTotal Assets=Fixed Assets+Working Capital (Current Assets less Current Liabilities)
bNet Income less Preferred Dividends