The Mathematics of Money

512 Chapter 12 Financial Statements

Recall that current assets are assets that can be readily converted to cash (within 1 year)

and current liabilities are obligations which must be met near term (again, within one

year). The current ratio seeks to evaluate how well equipped the business is to meet its

near-term obligations. If the current ratio is less than 1, this means that current liabilities

exceed current assets, which would raise doubts about the company’s ability to meet its

near-term financial obligations. If the current ratio is more than 1, current assets exceed

current liabilities; the higher the current ratio, the greater the confidence that the company

will be able to meet its near-term financial obligations.

The quick ratio seeks to accomplish the same thing as the current ratio. The quick ratio,

however, recognizes that some current assets may not be usable to pay off the company’s

obligations. The quick ratio is a stricter measure of the company’s ability to meet those

obligations. A company with a quick ratio below 1 may still not run into any difficulty,

since it would be expected that in the normal course of business inventory is being turned

into sales, but a quick ratio over 1 inspires far more confidence.

The debt-to-equity ratio measures just how far in debt the business is relative to its

overall resources. The larger this ratio is, though, the larger equity is in proportion to

liabilities, and so the more “breathing room” the company has in managing its debt. Since

Equity  Assets 
 Liabilities, as long as the liabilities are less than the assets this ratio

will be a positive number.

Example 12.3.4 Calculate the current, quick, and debt-to-equity ratios for Thomas

Hydrometer Sales and explain what they tell you about the company’s fi nancial health.

Current ratio 

$25,307,651

____________

$2,391,920

 10.58

The current ratio indicates that the company has 10.48 times as much in current assets as

current liabilities. This suggests that it is in a good position to meet its near-term fi nancial

obligations.

Quick ratio 

$25,307,651
$22,982,651

__________________________

$2,391,920



$2,325,000

___________

$2,391,920

 0.97

The quick ratio is less than 1, indicating that the company does not have enough assets

immediately available to cover its near-term liabilities. We can see that most of the com-

pany’s current assets are in inventory, explaining the difference between current and quick

ratios. While a quick ratio below 1 is potential for concern, the company probably will not run

into problems from this since it is not far below 1, the company can be expected to continue

selling its inventory, and the current liabilities are unlikely to all come due at once anyway.

Liabilities-to-equity ratio 

$12,714,975

____________

$20,535,025

 0.62

The company’s total liabilities amount to 62 cents for each $1 of equity. This suggests that

the company’s debt load is not excessive.

Valuation Ratios

An investor evaluating a business as a potential investment needs to be able to determine

whether the price for the company’s stock is reasonable on the basis of its financial posi-

tion. There is no absolute way of determining the fair price for a business, but investors can

employ a number of different measurements to help in determining a reasonable price.

In looking at the price per share of a company’s stock, it is helpful to know the company’s

earnings, assets, liabilities, sales, and so forth on a per share basis. Knowing how much the

company earned as a whole does not tell you much about the value of a single share of stock,

unless you also take into account how many shares those profits are divided among.

Any financial statement value can be converted to a per share value by dividing by the

overall value for the entire company by the number of shares. Some of the more commonly

used per share values are: