H 102
Everett Community College Tutoring Center
1
Financial Ratios
Covers Information from Accounting 201 and 202
Financial ratios are useful indicators of a firm’s performance and financial situation. Most ratios can be
calculated from information provided by the financial statements. Financial ratios can be used to
analyze trends and to compare the firm’s financials to those of other firms. In some cases, ratio analysis
can predict future bankruptcy.
Liquidity Ratios
Liquidity ratios provide information about a firm’s ability to meet its short-term financial obligations.
They are of particular interest to those extending short-term credit to the firm. Two frequently-used
liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.
The current ratio is the ratio of current assets to current liabilities:
Current Ratio = Current Assets
Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a
lower current ratio so that more of the firm’s assets are working to grow the business. Typical values for
the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a
higher current ratio in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items that are difficult to liquidate
quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity
that does not include inventory in the current assets. The quick ratio is defined as follows:
Quick Ratio = Current Assets – Inventory
Current Liabilities
The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These
assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.
Asset Turnover Ratios
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred
to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset
turnover ratios are receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts receivable and is
defined as follows:
Receivables Turnover = Annual Credit Sales
Accounts Receivable
