1. Financial ratios from the balance sheet
Now that we know about the balance sheet, let's move on to some financial ratios that can be computed with information from the balance sheet.
2. Current ratio
The current ratio is the proportion of a company's current assets to its current liabilities. Recall that current assets are assets that will reap benefits within one year, and current liabilities are burdens that have to be paid off within a year.
The benefits that the business gets in the short term from the current assets are usually used to pay off the current liabilities.
Thus, the current ratio is a measure of a company's ability to pay off its short-term burdens. A ratio higher than one implies that the company has enough assets to meet its short-term obligations.
3. Debt-to-equity ratio
The debt-to-equity ratio is the proportion of a company's total liabilities to its shareholders' equity. Debt is the company's total burden, which is essentially its total liabilities and can be thought of as the money that the company has borrowed from outsiders. Shareholders' equity is the money invested by the owners in the business.
So, this ratio gives us a measure of how much outside money versus the owner's money is being used in the company to run its operations. A ratio of more than 1 implies that a company uses relatively more debt to finance its activities. Such companies are called leveraged companies.
4. Equity multiplier ratio
The equity multiplier ratio is the proportion of a company's total assets to its shareholders' equity.
Assets are what reap economic benefits to the business and these assets have to be bought by the business. Shareholders' equity is the money that the owners have invested in the business.
Thus, this ratio gives a measure of how much of the assets are funded by the owners of the business. Note that all the assets have to be funded with something - recall the equation of accounting. If total shareholders' equity is less than assets, causing the ratio to be less than 1, it means that the company is also using debt to fund its assets.
5. Debt-to-assets ratio
The debt-to-assets ratio is the proportion of a company's total liabilities to its total assets.
It is a measure of financial health - whether the company has enough assets to pay off its financial burden.
It is closely related to the current ratio, however, the current ratio gives a measure of the business' capability in meeting its short-term obligations.
The debt-to-assets ratio gives a measure of the company meeting its obligations in general.
Note that if the ratio is more than 1, it implies that the company has relatively more liabilities than assets. This means that the shareholders' equity is negative, which follows from the main equation of accounting - assets equal to liabilities plus shareholders' equity. Such companies cannot exist - they become bankrupt.
6. Family of ratios
The ratios taught in this video fall under various families of financial ratios. Each family provides a picture of a certain part of the finances of a business.
Liquidity ratios give us a picture of the business' ability to meet its short term financial burdens.
Leverage ratios tell us how a company uses equity and debt to finance its operations.
Solvency ratios give us a picture of a company's financial health. It tells us whether it will be able to meet its financial obligations in general, not just in the short term like liquidity ratios.
7. Let's practice!
Now, let's practice computing some ratios!