Calculate Ratios That Analyze a Company's Short-Term Debt-Paying Ability
Ratios are expressions of logical relationships between items in the financial statements of a single period. Analysts can compute many ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g. balance sheet and income statement). The only limiting factor in choosing ratios is the requirement that the items used to construct a ratio have a logical relationship to one another.
Ratio analysis
Logical relationships exist between certain accounts or items in a company’s financial statements. These accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form called ratios. These ratios include: (1) liquidity ratios; (2) equity, or long-term solvency, ratios; (3) profitability tests; and (4) market tests.
Liquidity ratios indicate a company’s short-term debt-paying ability. Thus, these ratios show interested parties the company’s capacity to meet maturing current liabilities.
Current (or working capital) ratio Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current assets and, thus, shows the strength of the company’s working capital position. You calculate the current ratio by:
Current Assets |
Current Liabilities |
Short-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term creditors. Long-term creditors are also interested in the current ratio because a company that is unable to pay short-term debts may be forced into bankruptcy. For this reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum current ratio. A company can increase its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.
A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying customers, and/or slow-moving inventory. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up in current assets.
Acid-test (quick) ratio The current ratio is not the only measure of a company’s short-term debt-paying ability. Another measure, called the acid-test (quick) ratio, is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. Analysts exclude inventories and prepaid expenses from current assets to compute quick assets because they might not be readily convertible into cash. The formula for the acid-test ratio is:
Cash + Short-term investments + net current receivables |
Current Liabilities |
Since inventory and accounts receivable are a large part of a company's current assets, it is important to understand the company's ability to collect from their customers and the company's efficiency in buying and selling inventory.
Accounts receivable turnover Turnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the number of times per year that the average amount of receivables is collected. To calculate this ratio:
Net Sales |
AVERAGE Accounts receivable, net |
The accounts receivable turnover ratio provides an indication of how quickly the company collects receivables. For Synotech, Inc., we have the following information:
Net Sales | $ 10,498.80 |
Accounts Receivable, Net | |
January 1 | $ 1,340.30 |
December 31 | 1,277.30 |
Net Sales | $10,498.80 |
Avg. Accts Receivable = | $1,308.80 |
Number of days’ sales in accounts receivable The number of days’ sales in accounts receivable ratio is also called the average collection period for accounts receivable. Calculate it as follows:
Avg Accounts Receivable | x 365 days |
Net Sales |
We use a 365 days in a year for this calculation. Notice we are using Average accounts receivable here as well, but it can also be calculated with ending accounts receivable instead. Still using Synotech, Inc.'s information from above, we calculate 45.5 or 46 days from:
Avg. Accts Receivable = | $1,308.80 | x 365 Days |
Net Sales | $10,498.80 |
What about how a company handles inventory? We can prepare similar ratios for inventory turnover and number of days' sales in inventory.
Inventory turnover A company’s inventory turnover ratio shows the number of times its average inventory is sold during a period. You can calculate inventory turnover as follows:
Cost of Goods Sold |
Average Inventory |
Cost of goods sold | $ 5,341.30 |
Inventory | |
January 1 | $ 929.80 |
December 31 | 924.80 |
We first calculate average inventory as Jan 1 inventory $929.80 + Dec 31 inventory $924.80 = total inventory of $1,854.60 and divide by 2 for average inventory of $927.30. Next, we calculate inventory turnover:
Cost of Goods Sold = | $5,341.30 |
Average Inventory | $927.30 |
Average Inventory | x 365 days |
Cost of goods sold |
Average Inventory | $1,854.60 | x 365 Days |
Cost of Goods Sold | $5,341.30 |
Other things being equal, a manager who maintains the highest inventory turnover ratio (and lowest number of days) is the most efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales due to lack of adequate inventory. In attempting to earn satisfactory income, management must balance the costs of inventory storage and obsolescence and the cost of tying up funds in inventory against possible losses of sales and other costs associated with keeping too little inventory on hand.