1. Financial Statement Analysis - Liquidity
Ratios
In analyzing Financial Statements for the purpose of granting credit Ratios can be broadly
classified into three categories.
Liquidity Ratios
Efficiency Ratios
Profitability Ratios
Liquidity Ratios:
Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the liquidity of
the company as on a particular day i.e the day that the Balance Sheet was prepared. These
ratios are important in measuring the ability of a company to meet both its short term and long
term obligations.
FIRST LIQUIDITY RATIO
Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its
'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses
the 'working capital' relationship of current assets available to meet the company's current
obligations.
The formula:
Current Ratio = Total Current Assets/ Total Current Liabilities
An example from our Balance sheet:
Current Ratio = $261,050 / $176,522
Current Ratio = 1.48
The Interpretation:
Lumber & Building Supply Company has $1.48 of Current Assets to meet $1.00 of its Current
Liability
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
To use the Current Ratio Calculator Click here click here .

2. SECOND LIQUIDITY RATIO
Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by its
'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its
current assets, which might be obsolete or slow moving. Thus eliminating inventory from current
assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid
test of liquidity for a company. It expresses the true 'working capital' relationship of its cash,
accounts receivables, prepaids and notes receivables available to meet the company's current
obligations.
The formula:
Quick Ratio = Total Quick Assets/ Total Current Liabilities
Quick Assets = Total Current Assets (minus) Inventory
An example from our Balance sheet:
Quick Ratio = $261,050- $156,822 / $176,522
Quick Ratio = $104,228 / $176,522
Quick Ratio = 0.59
The Interpretation:
Lumber & Building Supply Company has $0.59 cents of Quick Assets to meet $1.00 of its Current
Liability
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
To use the Quick Ratio Calculator Click here click here .
THIRD LIQUIDITY RATIO
Debt to Equity Ratio: This ratio is obtained by dividing the 'Total Liability or Debt ' of a
company by its 'Owners Equity a.k.a Net Worth'. The ratio measures how the company is
leveraging its debt against the capital employed by its owners. If the liabilities exceed the net
worth then in that case the creditors have more stake than the shareowners.
The formula:
Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth
An example from our Balance sheet:
Debt to Equity Ratio = $186,522 / $133,522

3. Debt to Equity Ratio = 1.40
The Interpretation:
Lumber & Building Supply Company has $1.40 cents of Debt and only $1.00 in Equity to meet
this obligation.
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
To use the Debt to Equity Ratio Calculator Click here click here .
Efficiency Ratios:
Efficiency ratios are ratios that come off the the Balance Sheet and the Income Statement and
therefore incorporate one dynamic statement, the income statement and one static statement ,
the balance sheet. These ratios are important in measuring the efficiency of a company in either
turning their inventory, sales, assets, accounts receivables or payables. It also ties into the
ability of a company to meet both its short term and long term obligations. This is because if
they do not get paid on time how will you get paid paid on time. You may have perhaps heard
the excuse 'I will pay you when I get paid' or 'My customers have not paid me!'
FIRST EFFICIENCY RATIO
DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the average
time it takes to turn the receivables into cash and the age, in terms of days, of a company's
accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness
with which it converts its receivables into cash. This ratio is of particular importance to credit and
collection associates.
Best Possible DSO yields insight into delinquencies since it uses only the current portion of
receivables. As a measurement, the closer the regular DSO is to the Best Possible DSO, the
closer the receivables are to the optimal level.
Best Possible DSO requires three pieces of information for calculation:
Current Receivables
Total credit sales for the period analyzed
The Number of days in the period analyzed
Formula:
Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days
The formula:
Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period
that is being analyzed
An example from our Balance sheet and Income Statement:

4. Total Accounts Receivables (from Balance Sheet) = $97,456
Total Credit Sales (from Income Statement) = $727,116
Number of days in the period = 1 year = 360 days ( some take this number as 365 days)
DSO = [ $97,456 / $727,116 ] x 360 = 48.25 days
The Interpretation:
Lumber & Building Supply Company takes approximately 48 days to convert its accounts
receivables into cash. Compare this to their Terms of Net 30 days. This means at an average
their customers take 18 days beyond terms to pay.
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
To use the Regular DSO Calculator Click here click here .
SECOND EFFICIENCY RATIO
Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a company by
its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the rapiditity with
which the company is able to move its merchandise.
The formula:
Inventory Turnover Ratio = Net Sales / Inventory
It could also be calculated as:
Inventory Turnover Ratio = Cost of Goods Sold / Inventory
An example from our Balance sheet and Income Statement:
Net Sales = $727,116 (from Income Statement)
Total Inventory = $156,822 (from Balance sheet )
Inventory Turnover Ratio = $727,116/ $156,822
Inventory Turnover = 4.6 times
The Interpretation:
Lumber & Building Supply Company is able to rotate its inventory in sales 4.6 times in one fiscal
year.

5. Review the Industry Norms and Ratios for this ratio to compare their efficiency and see if
they are above, below or equal to the others in the same industry.
To use the Inventory Turnover Ratio Calculator Click here click here .
THIRD EFFICIENCY RATIO
Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts Payables'
of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much of their
suppliers money does this company use in order to fund its Sales. Higher the ratio means that
the company is using its suppliers as a source of cheap financing. The working capital of such
companies could be funded by their suppliers..
The formula:
Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100
An example from our Balance sheet and Income Statement:
Accounts Payables = $152,240 (from Balance sheet )
Net Sales = $727,116 (from Income Statement)
Accounts Payables to Sales Ratio = [$152,240 / $727,116] x 100
Accounts Payables to Sales Ratio = 20.9%
The Interpretation:
21% of Lumber & Building Supply Company's Sales is being funded by its suppliers.
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
Profitability Ratios:
Profitability Ratios show how successul a company is in terms of generating returns or profits on
the Investment that it has made in the business. If a business is Liquid and Efficient it should
also be Profitable.
FIRST PROFITIBILITY RATIO
Return on Sales or Profit Margin (%): The Profit Margin of a company determines its
ability to withstand competition and adverse conditions like rising costs, falling prices or declining
sales in the future. The ratio measures the percentage of profits earned per dollar of sales and
thus is a measure of efficiency of the company.
The formula:

6. Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100
An example from our Balance sheet and Income Statement:
Total Net Profit after Interest and Taxes (from Income Statement) = $5,142
Net Sales (from Income Statement) = $727,116
Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100
Return on Sales or Profit Margin = 0.71%
The Interpretation:
Lumber & Building Supply Company makes 0.71 cents on every $1.00 of Sale
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
To use the Return on Sales or Profit Margin Calculator click here .
SECOND PROFITABILITY RATIO
Return on Assets: The Return on Assets of a company determines its ability to utitize the
Assets employed in the company efficiently and effectively to earn a good return. The ratio
measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency
of the company in generating profits on its Assets.
The formula:
Return on Assets = (Net Profit / Total Assets) x 100
An example from our Balance sheet and Income Statement:
Total Net Profit after Interest and Taxes (from Income Statement) = $5,142
Total Assets (from Balance sheet) = $320,044
Return on Assets = [ $5,142 / $320,044] x 100
Return on Assets = 1.60%
The Interpretation:
Lumber & Building Supply Company generates makes 1.60% return on the Assets that it
employs in its operations.

7. Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
To use the Return on Assets or Profit Margin Calculator click here .
THIRD PROFITABILITY RATIO
Return on Equity or Net Worth: The Return on Equity of a company measures the ability of
the management of the company to generate adequate returns for the capital invested by the
owners of a company. Generally a return of 10% would be desirable to provide dividents to
owners and have funds for future growth of the company
The formula:
Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100
Net Worth or Owners Equity = Total Assets (minus) Total Liability
An example from our Balance sheet and Income Statement:
Total Net Profit after Interest and Taxes (from Income Statement) = $5,142
Net Worth (from Balance sheet) = $133,522
Return on Net Worth = [ $5,142 / $133,522] x 100
Return on Equity or Return on Net Worth = 3.85%
The Interpretation:
Lumber & Building Supply Company generates a 3.85% percent return on the capital invested by
the owners of the company.
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.