Performance Ratios Principles of Business and Finance
Current Ratio How is current ratio calculated? Equals current assets divided by current liabilities What does this ratio represent? Represents assets that the business could convert into cash in < 1 year compared to liabilities that it must pay in < 1 year; shows ability of company to pay debts as they become due. Ideally, this ratio should be over 1.0. Which is more favorable, higher or lower? Normally, the higher the ratio, the more favorable it is for the company.
Net Income Ratio How is Net Income ratio calculated? Equals total sales divided by net income (Hint: This is only total SALES, not total income.) What does this ratio represent? Shows the amount of sales needed for each dollar of net income. While there is not an ideal ratio, managers use this number to compare to past periods to determine how changes in sales affect net income. Which is more favorable, higher or lower? Normally, the lower the ratio, the more favorable it is for the company, as it takes less in sales to generate net income.
Debt to Equity Ratio How is debit to equity ratio calculated? Equals total liabilities divided by owner’s equity What does the ratio represent? Shows how much the business relies on money borrowed externally versus money from within the business. Ideally, this ratio should be less than 2.0. Which is more favorable, higher or lower? Normally, the lower this ratio, the more favorable it is for the company.
Return on Equity Ratio How is return on equity ratio calculated? Equals net income divided by owner’s equity (Net income can also be called net profit according to the text.) What does this ratio represent? Indicates the rate of return the owners/stockholders are receiving on their investments. There is not an ideal ratio; however, it is used to compare with other types of investments to see if there may be another investment that is more desirable. Which is more favorable, higher or lower? Normally, the higher the ratio, the more favorable it is for the company.