Definitions and terms used in Financial Ratios Calculator
- Refers to money in the physical form of currency. Cash includes money in the cash pan, petty cash, cash in the locker, bank account and customers’ checks.
- Marketable Security
- A near-cash (liquid) asset in the form of equity or debt instrument (share/stock, bond or note) that is listed on an exchange and can be readily bought or sold.
- Accounts Receivable
- Money owed to a company by customers (individuals or corporations) for goods or services that have been delivered or used, but not yet paid for. In it is also known as Sales on credit.
- The merchandise, raw materials and sub-assemblies, finished and unfinished products, consumables held available in stock by a business.
- Prepaid expenses
- Payments for goods and services that will be received in the near future. Typical prepaid expenses are: rent, insurance premium, advertising etc.
- The economic resources owned by a business. The assets are divided in two major classes: tangible assets (physical resources) and intangible assets (non-physical resources and rights like goodwill, copyrights, trademarks and patents).
- Current Assets
- The assets that are expected to be converted into cash or otherwise used up within a year or one business cycle (whichever is longer). Typical current assets include cash and cash equivalents, accounts receivable, inventory, marketable securities, the portion of prepaid expenses which will be used within a year and other assets that could be converted to cash in less than one year.
- Current Assets = Cash + Bank + Accounts Receivable + Marketable Securities + Inventory + Prepaid Expenses
- Fixed Assets
- An asset not directly sold to company’s consumers nor consumed during the normal course of a business. These are items of value which the company has bought and will use for an extended period of time (more than a year or a business cycle). Fixed assets normally include items such as land, buildings, plant, equipment, machinery, vehicles, furniture, office equipment, fixtures and fittings.
- Also known as Non-Current Assets, Long Term Assets or as Property, Plant and Equipment – PP&E
- Present obligations of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Liabilities are usually divided into two categories: current liabilities and long-term liabilities.
- Current liabilities (short term debt)
- Obligations or debts that are due within one fiscal year or the operating cycle. For example, accounts payable, accrued liabilities, dividends, unpaid taxes and other debts that are due within one year.
- Long-term liabilities
- Obligations or debts that are due in more than one year, such as notes payable, leases, mortgage loans and other bank loans, bond repayments and other items due in more than one year. The portion of long-term liabilities that must be paid within one year is classified as current liabilities.
- Represents the residual interest in the assets of the enterprise after liabilities are subtracted from assets.
- The amount of equity invested in a corporation by its owners. It consists of capital stock and additional paid-in capital.
- Retained earnings
- The portion of net income which is not distributed to stockholders (shareholders) as dividends but are either reinvested in the business or kept as a reserve for specific objectives (such as to pay debt or to purchase assets).
- Net Income
- The income that a company has after subtracting costs and expenses from the total revenue. Net income is sometimes called the bottom line.
- Also known as earnings, net earnings or net profit
- Net Sales
- The amount of revenue generated by a company after the deduction of returns, allowances for damaged or missing goods and any discounts allowed.
- Net sales = Gross sales – Sales returns and allowances
- Cost of Goods Sold (COGS)
- Direct cost attributable to the production or purchasing of the goods sold by a company. It is also referred as Cost of sales.
- Gross Profit
- The difference between Net Sales and its Cost of Goods Sold, before deducting overhead, payroll, taxes, interest and other operating expenses.
- Gross profit = Net sales – Cost of Goods Sold
- Operating Expenses
- The expenses incurred by a business in its normal day-to-day operations, but not directly associated with production of goods. Operating expenses include payroll, sales commissions, employee benefits and pension contributions, transportation and travel, amortization and depreciation, rent, repairs etc. These expenses are divided into selling expenses and administrative and general expenses.
- Operating Income
- A measure of a company’s profitability that excludes interest and income tax expenses. This is the surplus generated by operations and equals gross profit less all operating expenses.
- Also known as Earnings before Interest and Taxes – EBIT
- Operating Income = Gross profit – Operating Expenses
- Interest Expenses
- A fee paid on borrowed assets, the price paid for the use of borrowed money.
- Income tax
- The tax levied on the income of a company.
- Number of employees
- The number of individuals who work full time or part-time for the company.
Financial Statements Analysis
Financial statements analysis is the process of examining relationships among elements of the the company’s “accounting statements” or financial statements (balance sheet, income statement, statement of cash flow and the statement of retained earnings) and making comparisons with relevant information.
Financial statements analysis is a valuable tool used by investors, creditors, financial analysts, owners, managers and others in their decision-making process.
The most common known types of financial statements analysis are:
- Horizontal Analysis: financial information are compared for two or more years for a single company;
- Vertical Analysis: each item on a single financial statement is calculated as a percentage of a total for a single company;
- Ratio Analysis: compare items on a single financial statement or examine the relationships between items on two financial statements.
Financial Ratios Analysis
Financial ratios analysis is the most common form of financial statements analysis. Financial ratios illustrate relationships between different aspects of a company’s operations and provide relative measures of the firm’s conditions and performance. Financial ratios may provide clues and symptoms of the financial condition and indications of potential problem areas.
Financial ratios generally hold no meaning unless they are compared against something else, like past performance, another company/competitor or industry average. Thus, the ratios of firms in different industries, which face different conditions are usually hard to compare.
Financial ratios can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies within an industry. In addition, tracking various ratios over time is a powerful way to identify trends. Ratio analysis, when performed regularly over time, can also give help small businesses recognize and adapt to trends affecting their operations.
Financial ratios are also used by bankers, investors, and business analysts to assess various attributes of a company’s financial strength or operating results. This is another reason why business owners need to understand financial ratios because, very often, a business’s ability to obtain financing or equity financing will depend on the company’s financial ratios.
Financial ratios are categorized according to the financial aspect of the business which the ratio measures:
- Liquidity ratios examine the availability of company’s cash to pay debt.
- Profitability ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return.
- Leverage ratios examine the company’s methods of financing and measure its ability to meet financial obligations.
- Efficiency ratios measure how quickly a firm converts non-cash assets to cash assets.
- Market ratios measure investor response to owning a company’s stock and also the cost of issuing stock.
Despite all the positive uses of financial ratios, however, business managers and owners are still encouraged to know the limitations of ratios and approach financial ratio analysis with a degree of caution.