Accounting – Basic Financial Ratios
When the term ratio is mentioned, many people get startled and remember the complex ratio problems they encountered in high school. It is true that many of those ratios left people frightened. However, this should not be the case when talking about financial ratios. In fact, financial ratios are of greater benefit to your business and if understood and applied as they should, can help you make more informed decisions in your business. Here are some of the ratios you need to know.
Working capital ratio (Also see Components of Working Capital) is the ratio of liquidity since it helps one understand and assess the health situation of the business; how easy it is to turn the company’s assets into cash and pay short term obligations. The ratio can be calculated by the formula:
Working capital = Current assets/current liabilities
This ratio is popularly referred to as acid test. It is calculated by subtracting inventories from current assets and dividing the results with the liabilities in the balance sheet. The ratio is intended to show whether current liabilities are covered by cash or assets that can easily be converted into cash. Inventories are excluded because they take time before they can be converted into liquid assets or cash flow.
Earnings Per Share (EPS)
When you buy assets such as stock, you are directly participating in future earning of the company in question. EPS measures the net income that will be earned by each share on a company’s stock. The ratio is arrived at by dividing the company’s net income by the weighted average number of common shares outstanding in that year.
Price Earnings Ratio (P/E)
The ratio reflects the assessment of the future earnings. The ratio is arrived at by determining the share price of the company’s stock and dividing it with EPS.
The ratio is calculated by adding short term and the long term debt and dividing the result with the book value of the shareholders equity.
Return On Equity
The ratio is intended to help shareholders know how efficient the capital is used in the business to generate the bottom line of the income statement. It is calculated by dividing the firm’s net earnings (after subtracting dividends and taxes) with the company’s common equity dollars. If the ROE is high, it indicates that the company is more efficient in generating profits.
These are important ratios that can be relied on when considering to invest in stock. They help investors pick on the best stock to invest in. Ratios can be relied on if you want to build wealth in a steady way. To optimize on the ratios, they must be analyzed after looking at the industry norms and specific requirements. Alternatively, you could consider engaging an accounting firm in Johor Bahru and let the expert to crunch the numbers for you.