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Before we begin our discussion on ratio analysis, it's important to have an understanding of a financial ratio, which evaluates the relationship between specific items on a financial statement.
The first step of ratio analysis is calculating our profitability ratios, which measure the operating performance of a company, helping a business to understand and evaluate its performance.
Today we will be covering the following profitability ratios:
| Profitability Ratio | Measurement |
|---|---|
| Rate of return on sales | Measures managerial efficiency, as well as profitability |
| Return on total assets | Measures the effective use of assets and managerial efficiency |
| Asset turnover | Measures the use of assets to make sales |
The formula for rate of return on sales is net income divided by net sales. This ratio will tell us how profitable we are as a business.
EXAMPLE
Suppose net income is $257,500 and net sales is $925,000, we would get a rate of return on sales of 27.8%.
Next, the formula for return on total assets is income before interest expense and taxes, divided by total assets. This ratio is going to tell us how effectively we use our assets to generate income.
EXAMPLE
Suppose the income before interest expense and taxes is $262,500 and total assets is $980,000, then we get a return on total assets of 26.8%.
Lastly, the formula for asset turnover ratio is net sales divided by total assets. This ratio helps us measure the use of assets to make sales.
EXAMPLE
Suppose net sales is $925,000 and total assets is $980,000, we can see that our assets turn over 0.9 times during the year.
Now that we've learned how to calculate profitability ratios, let's turn our attention to liquidity ratios. Liquidity ratios measure the ability of a company to pay debts when they are due. In other words, they help us understand our ability to pay our debt obligations.
Today we will discuss the following liquidity ratios:
| Liquidity Ratio | Measurement |
|---|---|
| Current Ratio | Measures how much in current assets a company has to pay its current liabilities |
| Inventory Turnover | Measures the number of times a company's inventory is sold and replaced |
The formula for current ratio is current assets divided by current liabilities.
EXAMPLE
Suppose that current assets is $580,000 and current liabilities is $155,000, we get a current ratio of 3.74, which means we have 3.74 times more current assets than we do current liabilities.
Now let's turn our attention to inventory turnover. Inventory turnover is calculated as cost of goods sold divided by average inventory.
EXAMPLE
Suppose cost of goods sold is $450,000 and average inventory is $225,000, we see that inventory turnover is 2.0 times. This is the number of times the inventory is sold and replaced.
It's important to note that in order for these liquidity ratios to have context, we would need to know information such as what our ratios were last year, other companies' ratios, and the industry standards.
Source: THIS TUTORIAL WAS AUTHORED BY EVAN MCLAUGHLIN FOR SOPHIA LEARNING. PLEASE SEE OUR TERMS OF USE.
