Law of Office Management and Accounting

Accounting Ratios
6th December , 2005.

1. CURRENT RATIO / WORKING CAPITAL RATIO

This ratio is the most commonly used indicator of a companys short-run solvency. It is
considered to be a better indicator of a companys current debt-paying ability than simply
using working capital. In the past, as a rule of thumb, a 2.0 current ratio was considered
to be satisfactory. Too high a current ratio as compared to similar companies in the same
industry may indicate inefficient management of current assets. This ratio indicates in a
general sort of way, the ability of a business to meet its short-term liabilities as they fall
due, out if its short-term assets.
RATIO

Current Assets
Current Liabilities

390 000
112 000

3.5 : 1

2. QUICK ASSET RATIO / ACID TEST RATIO

The acid-test or quick ratio is a more sever test of a companys short-term debt-paying
abilities. In this ratio only the current assets that may be easily converted into cash are
used in the calculation. These assets are referred to as quick assets, and they generally
consist of cash, short-term marketable securities, accounts receivable and short-term
notes receivable. The ratio highlights potential solvency problems resulting from a poor
mix of current assets. The use of this ratio shows the lower liquidity of a company with a
high investment in inventory that would not be revealed in the current ratio. A good ratio
has been used as a general rule of 1.0 : 1 . However today more attention is placed on
industry practices and the companys typical operations.
RATIO

Quick Assets/ Liquid Assets (cash + receivable) 38000 +117 000 =

Current Liabilities

155 000
112 000
1.4 : 1

3. SHAREHOLDERS EQUITY RATIO

This ratio shows the relationship between equity capital ( shares) and the total assets of
the company. It is used to show whether the company has more equity/ shares than other
assets.
RATIO

Shareholders Equity
Total Assets

638 000
.67 : 1
950 000

4. CREDITORS EQUITY RATIO / DEBT RATIO

The debt ratio shows the percentage of total assets contributed by creditors. This ratio is
subtracted from 100% to show the percentage of total assets contributed by stockholders.
The desired mix or relationship between the debt and equity ratios depends on the

Law of Office Management and Accounting

Accounting Ratios
6th December , 2005.

industry. In general, creditors prefer to see a lower debt ratio because if business declines
it is more likely that the company will be able to pay its interest costs. Up to a point,
stockholders prefer to see a higher debt ratio, especially when the company is favourably
trading on the equity or applying favourable financial leverage. A very high debt ratio is
usually a disadvantage when a company wants to attract shareholders.
RATIO

Total Liabilities
Total Assets

312 000
638 000
950 000
860 000
(2000) .32 : 1

( 1999) .74 : 1

5. ACCOUNTS RECEIVABLE TURNOVER

Dividing the net credit sales by average net accounts receivable shows how many times
the average receivables are turned over or collected each period. The accounts receivable
turnover is a measure of the efficiency with which the company collects its receivables
and coverts them back into cash. As a general rule, the higher the turnover the better,
because the company has less resourced tied up in receivables, collects these resources at
a faster pace and usually has fewer uncollectible accounts.
RATIO

Net Credit Sales

117 000
Average receivable before deduction of allowances (117 +86) / 2 101 500
1.2 : 1

6. NUMBER OF DAYS SALES UNCOLLECTED

RATIO

360
Turnover of Receivables

7. MERCHANDISE TURNOVER

RATIO

Cost of Goods Sold

Average Inventory

Law of Office Management and Accounting

Accounting Ratios
6th December , 2005.

8. NET INCOME AS A PERCENTAGE OF NET SALES

RATIO

Net Income
Net Sales

75 000
900 000

.08 : 1

9. NET INCOME AS A RETURN ON SHAREHOLDERS EQUITY (RETURN ON

EQUITY )
The management of a company not only has the responsibility of efficiently using the
companys assets to earn income, but also to earn a satisfactory return for its stockholders
on their equity (investment). A weakness of the ratio is that it does not consider the
current values of the assets or investments because it is shown in the financial statements
based on historical cost dollar amounts.
RATIO

10.

Net Income
75 000
Shareholders Equity
638 000

.12 : 1

EQUITY PER COMMON SHARE/ EARNINGS PER SHARE / BOOK

VALUE PER COMMON SHARE

This ratio shows the net assets per share of common stock. It is sometimes called the
liquidation value per share. (Liquidation occurs when a company ceases to operate, sells
all its assets and pays off its debts). Although book value is frequently calculated, or
several reasons it is actually not very useful for showing a companys financial stability.
First most companies are ongoing businesses so that a liquidation value is not important.
Second, even if a liquidation value were important, the book value is based on assets
recorded primarily at historical costs and not a current liquidation selling prices. Third,
what is important in evaluating a companys stability is the market value per share of its
common stock. The book value per common share is computed by dividing the number o
common shares outstanding into this remaining stockholders equity.
RATIONet Income accruing to common shareholders
Common Shares Outstanding

66 000
5 000

13.2 : 1

Law of Office Management and Accounting

Accounting Ratios
6th December , 2005.