Liquidity Ratio - Liquidity ratios is the ratio which measure the extent to which the firm can

meat its immediate obligations. Liquidity ratios also reflect the firm’s ability to meet short term
financial contingencies that might arise.

There are two important liquidity ratios: the current ratio and the quick (or acid-test) ratio.

(A) Current Ratio – Current Ratio measures the number of times the firm can cover its
current liabilities with its current assets. The current ratio assumes that both accounts
receivable and inventory can be easily converted to cash. Higher Value of the current
ratio indicate that the firm liquid is in good position.

Current assets

Current Ratio = Current liabilities

(B) Quick Ratio - The quick (acid-test) ratio measures the firm’s ability to meet its current
obligations with the most liquid of its current assets. The quick ratio or acid-test ratio is
meant to reflect the firm’s stability to pay its short term obligations, the higher the quick
ratio, the more liquid the firm’s position.

Current Assets – Inventory

Quick Ratio = Current Liabilities

Activity Ratios – Activity Ratios measures how well the firm is managing various classes of
assets. Activity Ratios are called turnover ratios because they show how rapidly assets are being
converted into sales.

Four important activity ratios exist: inventory turnover, average collection period, fixed asset
turnover, and total asset.

(A) Inventory Turnover - Inventory turnover measures the liquidity of the

firm’s inventory how quickly goods are sold and replenished. The higher
the inventory turnover, the more times the firm is selling, or “turning
over,” its inventory turnover.

Cost of good sold

Inventory Turnover = Inventory

(B) Average Collection Period - The average collection period is a measure of

how long it takes a firm to convert a credit sale (internal store credit, not
credit card sales) into a usable form.

Account Receivable
 Collection Period = Average Sales per day

(C) Fixed Asset Turnover - The fixed asset turnover ratio measures how
efficiently the firm is using its assets to generate sales. This ratio is
particularly important for businesses with a lot of equipment or building.

Sales

Fixed Asset Turnover = Net Fixed Assets

(D) Total Asset Turnover - The total asset turnover ratio measures how
efficiently the firm uses all of its assets to generate sales, so a high ratio
generally reflects good overall management.

Sales

Total Asset Turnover = Total Assets

Leverage Ratios - Leverage ratios measure the extent to which a firm uses debt as a source of
financing and its ability to service that debt. Two important leverage ratios are the debt ratio and
the times-interest-earned ratio.

(A) Debt Ratio - The debt ratio measures the proportion of a firm’s total assets that is
acquired with borrowed funds

Total Debt

Debt Ratio = Total Assets

(B) Time Interest Earned Ratio - Times interest earned is the sum of net income before taxes
and interest expense divided by interest expense

Operating Income

Time Interest Earned Ratio = Interest Expense

Profitability Ratios - Profitability ratios are used to measure the ability of a company to turn
sales into profits and to earn profits on assets committed. There are three important profitability
ratios: net profit margi, return on assets, and return on equity.

(A) Net Profit Margin - The profit margin is an important ratio because it describes how well
a Dollar of sales is squeezed by the firm into profit.

Net Profit Margin = Net Income / sales

(B) Return on Assets - This ratio is to measure how profitably the firm has used its assets.
Net income. The higher this ratio is, the better the firm will be High ratio shows effective
management and good chances for future growth.

Net Profit after taxes

Return on Assets = Total Assets

(C) Return on Equity - The return on equity measures the return the firm earned on its
owner’s investment in the firm. In general, the higher this ratio, the better off financially
the owner will be.

Net Profit after taxes

Return on Equity = Owner’s Equity