Ratios

Liquidity Ratios

Liquidity Ratios are ratios that come off the Balance Sheet and hence measure the liquidity of the company as on a particular day i.e. the day that the Balance Sheet was prepared. These ratios are important in measuring the ability of a company to meet both its short term and long term obligations.

FIRST LIQUIDITY RATIO

Current Ratio

This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations.

The formula:

Current Ratio = Total Current Assets/ Total Current Liabilities

An example from our Balance sheet:

Current Ratio = $261,050 / $176,522

Current Ratio = 1.48

The Interpretation:

Lumber & Building Supply Company has $1.48 of Current Assets to meet $1.00 of its Current Liability

SECOND LIQUIDITY RATIO

Quick Ratio:

This ratio is obtained by dividing the 'Total Quick Assets' of a company by its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true 'working capital' relationship of its cash, accounts receivables, prepaid and notes receivables available to meet the company's current obligations.

The formula:

Quick Ratio = Total Quick Assets/ Total Current Liabilities

Quick Assets = Total Current Assets (minus) Inventory

An example from our Balance sheet:

Quick Ratio = $261,050- $156,822 / $176,522

Quick Ratio = $104,228 / $176,522

Quick Ratio = 0.59

The Interpretation:

Lumber & Building Supply Company has $0.59 cents of Quick Assets to meet $1.00 of its Current Liability

THIRD LIQUIDITY RATIO

Debt to Equity Ratio

This ratio is obtained by dividing the 'Total Liability or Debt ' of a company by its 'Owners Equity a.k.a Net Worth'. The ratio measures how the company is leveraging its debt against the capital employed by its owners. If the liabilities exceed the net worth then in that case the creditors have more stake than the shareowners.

The formula:

Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth

An example from our Balance sheet:

Debt to Equity Ratio = $186,522 / $133,522

Debt to Equity Ratio = 1.40

The Interpretation:

Lumber & Building Supply Company has $1.40 cents of Debt and only $1.00 in Equity to meet this obligation.

Profitability Ratios:

Profitability Ratios show how successful a company is in terms of generating returns or profits on the Investment that it has made in the business. If a business is liquid and efficient it should also be Profitable.

FIRST PROFITIBILITY RATIO

Return on Sales or Profit Margin (%)

The Profit Margin of a company determines its ability to withstand competition and adverse conditions like rising costs, falling prices or declining sales in the future. The ratio measures the percentage of profits earned per dollar of sales and thus is a measure of efficiency of the company.

The formula:

Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100

An example from our Balance sheet and Income Statement:

Total Net Profit after Interest and Taxes (from Income Statement) = $5,142

Net Sales (from Income Statement) = $727,116

Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100

Return on Sales or Profit Margin = 0.71%

The Interpretation:

Lumber & Building Supply Company makes 0.71 cents on every $1.00 of Sale

SECOND PROFITABILITY RATIO

Return on Assets

The Return on Assets of a company determines its ability to utilize the Assets employed in the company efficiently and effectively to earn a good return. The ratio measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency of the company in generating profits on its Assets.

The formula:

Return on Assets = (Net Profit / Total Assets) x 100

An example from our Balance sheet and Income Statement:

Total Net Profit after Interest and Taxes (from Income Statement) = $5,142

Total Assets (from Balance sheet) = $320,044

Return on Assets = [ $5,142 / $320,044] x 100

Return on Assets = 1.60%

The Interpretation:

Lumber & Building Supply Company generates makes 1.60% return on the Assets that it employs in its operations.

THIRD PROFITABILITY RATIO

Return on Equity or Net Worth

The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividends to owners and have funds for future growth of the company

The formula:

Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100

Net Worth or Owners Equity = Total Assets (minus) Total Liability

An example from our Balance sheet and Income Statement:

Total Net Profit after Interest and Taxes (from Income Statement) = $5,142

Net Worth (from Balance sheet) = $133,522

Return on Net Worth = [ $5,142 / $133,522] x 100

Return on Equity or Return on Net Worth = 3.85%

The Interpretation:

Lumber & Building Supply Company generates a 3.85% percent return on the capital invested by the owners of the company.

Efficiency Ratios:

Efficiency ratios are ratios that come off the Balance Sheet and the Income Statement and therefore incorporate one dynamic statement, the income statement and one static statement, the balance sheet. These ratios are important in measuring the efficiency of a company in either turning their inventory, sales, assets, accounts receivables or payables. It also ties into the ability of a company to meet both its short term and long term obligations. This is because if they do not get paid on time how will you get paid on time. You may have perhaps heard the excuse 'I will pay you when I get paid' or 'my customers have not paid me!'

FIRST EFFICIENCY RATIO

DSO (Days Sales Outstanding)

The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness with which it converts its receivables into cash, This ratio is of particular importance to credit and collection associates.

Best Possible DSO yields insight into delinquencies since it uses only the current portion of receivables. As a measurement, the closer the regular DSO is to the Best Possible DSO, the closer the receivables are to the optimal level.
Best Possible DSO requires three pieces of information for calculation:

1)   Current Receivables

2)   Total credit sales for the period analyzed

3)   The Number of days in the period analyzed

Formula:

Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days

The formula:

Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period that is being analyzed

An example from our Balance sheet and Income Statement:

Total Accounts Receivables (from Balance Sheet) = $97,456

Total Credit Sales (from Income Statement) = $727,116

Number of days in the period = 1 year = 360 days ( some take this number as 365 days)

DSO = [$97,456 / $727,116 ] x 360 = 48.25 days

The Interpretation:

Lumber & Building Supply Company takes approximately 48 days to convert its accounts receivables into cash. Compare this to their Terms of Net 30 days. This means at an average their customers take 18 days beyond terms to pay.

SECOND EFFICIENCY RATIO

Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the rapidity with which the company is able to move its merchandise.

The formula:

Inventory Turnover Ratio = Net Sales / Inventory

It could also be calculated as:

Inventory Turnover Ratio = Cost of Goods Sold / Inventory

An example from our Balance sheet and Income Statement:

Net Sales = $727,116 (from Income Statement)

Total Inventory = $156,822 (from Balance sheet )

Inventory Turnover Ratio = $727,116/ $156,822

Inventory Turnover = 4.6 times

The Interpretation:

Lumber & Building Supply Company is able to rotate its inventory in sales 4.6 times in one fiscal year

THIRD EFFICIENCY RATIO

Accounts Payable to Sales (%)

This ratio is obtained by dividing the 'Accounts Payables' of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much of their supplier’s money does this company use in order to fund its Sales. Higher the ratio means that the company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers..

The formula:

Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100

An example from our Balance sheet and Income Statement:

Accounts Payables = $152,240 (from Balance sheet )

Net Sales = $727,116 (from Income Statement)

Accounts Payables to Sales Ratio = [$152,240 / $727,116] x 100

Accounts Payables to Sales Ratio = 20.9%

The Interpretation:

21% of Lumber & Building Supply Company's Sales is being funded by its suppliers.

Deduction & Induction

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In logic, we often refer to the two broad methods of reasoning as the deductive and inductive approaches.

Deductive reasoning works from the more general to the more specific. Sometimes this is informally called a "top-down" approach. We might begin with thinking up a theory about our topic of interest. We then narrow that down into more specific hypotheses that we can test. We narrow down even further when we collect observations to address the hypotheses. This ultimately leads us to be able to test the hypotheses with specific data -- a confirmation (or not) of our original theories.

Inductive reasoning works the other way, moving from specific observations to broader generalizations and theories. Informally, we sometimes call this a "bottom up" approach (please note that it's "bottom up" and not “bottoms up" which is the kind of thing the bartender says to customers when he's trying to close for the night!). In inductive reasoning, we begin with specific observations and measures, begin to detect patterns and regularities, formulate some tentative hypotheses that we can explore, and finally end up developing some general conclusions or theories.

These two methods of reasoning have a very different "feel" to them when you're conducting research. Inductive reasoning, by its very nature, is more open-ended and exploratory, especially at the beginning. Deductive reasoning is narrower in nature and is concerned with testing or confirming hypotheses. Even though a particular study may look like it's purely deductive (e.g., an experiment designed to test the hypothesized effects of some treatment on some outcome), most social research involves both inductive and deductive reasoning processes at some time in the project. In fact, it doesn't take a rocket scientist to see that we could assemble the two graphs above into a single circular one that continually cycles from theories down to observations and back up again to theories. Even in the most constrained experiment, the researchers may observe patterns in the data that lead them to develop new theories.

Perceptual speed 

is the ability to quickly and accurately compare letters, numbers, objects, pictures, or patterns. in tests of perceptual speed the things to be compared may be presented at the same time or one after the other. candidates may also be asked to compare a presented object with a remembered object.