Ratio Analysis of Financial Statements

One method of analyzing financial statements is by ratios. These comparisons of different areas of the financial statement are expressed as percentages or ratios like 2 to 1, 2:1, or 2/1.

There is usually a target or comparative general rule to measure against your business. For example, in the Current Ratio, a 2:1 ratio is considered adequate. However, keep in mind that all businesses are different, and that one bad ratio doesn't necessarily mean your business is in trouble. This is just one way of analyzing your business.

There are several ratios, but four of the most commonly used are below:

Current Ratio

The current ratio is defined as Total Current Assets divided by Total Current Liabilities. A good ratio is 2 to 1 or higher.

Return on Equity

This ratio is defined as Net Profit divided by Equity. The ratio needs to be compared against other investment opportunities. Generally, 10% or higher is good.

Debt-to-Equity Ratio

This ratio is defined as Total Liabilities divided by Equity. A ratio of one or lower is good. (The lower the ratio, the more stable your position.)

Average Collection Period

This ratio is defined as Accounts Receivable divided by Average Sales Per Day. (To determine the Average Sales Per Day, divide Net Yearly Sales by 365.) A good measure is that the average collection period must not exceed 1.33 times your credit terms. Therefore, if you allow 30 days for payment terms, your Average Collection Period must not exceed 40 days.