Notes

Learn about financial ratios. Understand what a financial ratio is, identify the types of financial ratios, and see what constitutes financial ratio analysis.
Financial Statement Ratios Defined
The financial statements are the end result of all the work that is done in the accounting cycle. But have you ever wondered why they're so important? Sure, they do provide an awful lot of numbers, but do the numbers alone tell you what you want to know about a business?

Most of the time, financial statement users need a little more information to get the full picture of a business's finances. That's where financial statement ratios come into play. Financial statement ratios are measures of the efficiency and productivity of a business that are calculated using information found in the financial statements.

The Ratios
There are five basic financial statement ratios that we can use to see how well a company is performing. They are the current ratio, the quick ratio, earnings per share, debt-to-assets ratio, and the return on equity.

The first ratio is called the current ratio, or the working capital ratio. This ratio measures the amount of current assets that a company has for every dollar of current liabilities. It is calculated by dividing current assets by current liabilities.

The second ratio that is specific to information found on the balance sheet is the quick ratio. The quick ratio measures the number of dollars in cash and cash equivalents and accounts receivables that there are for every one dollar in liabilities. It is calculated by adding cash and cash equivalents and accounts receivable together and dividing that total by the amount of current liabilities.

The third ratio is earnings per share. Earnings per share, which is generally called EPS, measures how much net income is earned per share of a company's common stock. This ratio is calculated by dividing net income by the weighted average shares of common stock outstanding.

Debt-to-assets is a fourth ratio that's important to a company. It tells how many assets a company has that are financed by debt, and it's calculated by dividing total liabilities by total assets. The lower the debt-to-assets ratio is, the better off the company is.

The last member of the common financial statement ratios is the return on equity. Return on equity is a measure of the return on each dollar invested by stockholders. The way to calculate this is to divide net income by the average stockholder's equity. It is very important to note that the information you need to calculate these ratios comes from both the balance sheet and income statement of a company.

Examples
So let's look at a balance sheet and income statement and calculate these ratios.

Example balance sheet
example of balance sheet
Example income statement
example of an income statement
What are the current ratio and the quick ratio for Wasabi International? The current ratio is current assets divided by current liabilities. That means, if you look at the balance sheet, $400,000 / $210,000. So the current ratio is 1.9.

The quick ratio is the current assets minus inventories, divided by current liabilities. Let's look back at the balance sheet. Quick ratio is ($400,000 - $200,000) / $210,000. The end result is a quick ratio of 0.83.

So what are the earnings per share?

EPS = Net income/ shares of stock outstanding. Net income you find on the income statement. Net income is $154,200. Now look back on the balance sheet, and you'll see that the number of shares outstanding is 150,000.

EPS = $154,200 / 150,000

EPS = $1.03

Now, what's the debt-to-assets ratio? Debt-to-assets is calculated by dividing the total liabilities by the total assets. These are both found on the bottom of the balance sheet. For Wasabi International, the debt-to-assets is $335,000 / $575,000, so the debt-to-asset ratio is 0.58.

Now, what's the return on equity? On this one, you'll get information on the income statement and the balance sheet, as well. Net income is $154,200. It's divided by the $240,000 in stockholder's equity. That gives you a return on equity of 0.64.

Interpreting the Ratios
Ok. So now we have all these ratios figured out, but what do they mean?

The current ratio is 1.9. That means that for every $1 in liabilities, the company has $1.90 of assets.

The quick ratio of 0.83 means that for every $1 in liabilities, there's $0.83 of liquid assets available to cover them. Liquid assets are those assets that can easily be converted to cash. Most of the time, potential creditors and investors want to see this ratio be at least 1, but this slightly lower figure that represents the amount of liquid assets that are available to cover liabilities is generally considered acceptable.

Earnings per share is a fairly simple ratio because it gives you a flat dollar amount of what is being earned on every share of stock. In this case, for every one share of stock, an investor is earning $1.03.

A debt-to-assets ratio of 0.58 means that 58% of the assets of Wasabi International were financed by debt.

A 0.64 return on equity ratio means that for every dollar that an investor invests in the company, they earn a 64% return on that investment. Higher return on equity percentages tells investors that company management is wisely spending their money, so they're more than likely profitable.

Lesson Summary
Financial statement ratios are measures of the efficiency and productivity of a business that are calculated using information found on the financial statements. There are five basic ratios that can be used to fulfill this mission.

The current ratio, or the working capital ratio, measures the amount of current assets that a company has for every dollar of current liabilities, and it's calculated by dividing current assets by current liabilities.

The quick ratio measures the number of dollars in cash and cash equivalents and accounts receivable that there are for every one dollar in liabilities. It's calculated by adding cash and cash equivalents and accounts receivable together and dividing that total by the amount of current liabilities.

The third ratio is earnings per share, or EPS, which measures how much net income is earned per share of a company's common stock. It's calculated by dividing net income by the number of shares of common stock outstanding.

The debt-to-assets ratio tells how many assets a company has that are financed by debt and is calculated by dividing total liabilities by total assets.

The last ratio is the return on equity. Return on equity is a measure of the return on each dollar invested by stockholders and is calculated by dividing net income by the average stockholder's equity. Each of these ratios gives specific information that helps paint the complete picture of a company's financial status.