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In the example above you have total current assets of $50,000 and current liabilities of $20,000. Generally, a ratio of 2.5 is an excellent, rarely attained ratio, and means you have $2.50 in current asset value to cover every $1 of current liability.
Suppose you sell product and maintain inventory. The quick ratio then applies, and it equals:
(Total Current Asset - Inventory) / Total Current Liability
($50,000 - $20,000) / $20,000 = 1.5
Excluding an inventory of $20,000, you now have only $1.50 of current assets to cover every $1 of current liabilities. 1.5 remains a good quick ratio in many industries. But remember your inventory is listed at your cost, not the anticipated retail value. The concept behind this ratio assumes it is harder to readily liquidate inventory if the need arises.
Earnings before interest (on notes payable) and taxes is a coverage ratio intended to show how well your company can service its debt. The formula is:
Earnings before Interest & Taxes / Annual Interest Expense
$100,000 / $10,000 = 10.0
You have $10 of earnings before interest expense and taxes to pay for every dollar of interest expense. A higher ratio demonstrates a greater ability to pay interest expense. Remember you pay interest expense before income tax. And this ratio is of great concern to lenders. They are the recipients of your interest expense.
Finally, operating ratios are intended to show how well the company manages its assets to generate sales. In this case we use the example of net sales-to-net fixed assets (original fixed asset value minus accumulated depreciation):
Net Sales / Net Fixed Assets
$120,000 / $50,000 = 2.4
In other words, you are generating $2.40 in net sales (total sales minus cost of sales) for every $1 of net fixed assets. In many industry sectors this is an excellent ratio.
These are simple yet excellent tools to analyze financial performance. And they become even more valuable when comparing your financial statements from one year to the next. But you also want to compare your results to industry standards. Those standards are a reflection of your industry's financial performance. It is good business practice to know how well you perform from one year to the next, but equally important to know where you stand in comparison to the competition.
For more detailed information about ratio analysis I suggest you visit the web site of Robert Morris Associates or Dunn & Bradstreet.
© 2000, Carroll Stephen Windhaus
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