A financial statement ratio is simply a comparison of one number with another. Though you may not use this term to describe such relationships, you're already familiar with many ratios. Miles per gallon, price per pound, calories per serving of your favorite dessert — all are ratios used in everyday life.
The following three balance sheet ratios are paramount:
- Current ratio. To arrive at this ratio, divide current assets by current liabilities. For your company, current assets might include cash, short-term investments, accounts receivable, inventory, and supplies. Such assets are "current" because you expect to use them up in the coming year or operating cycle. Current liabilities are similarly defined. Such amounts might include accounts payable, payroll, or the portion of long-term debt that's payable in the near term.
The higher the ratio, the better your firm's liquidity. If you have a current ratio of 3:1, that means your current assets are three times the amount needed to pay off your current obligations. If the ratio is trending downward from one balance sheet to the next, your ability to service short-term debts is also declining. If the ratio drops below 1:1, your ability to meet current obligations may be hanging by a thread.
- Working capital. Though not technically a ratio (the number isn't a quotient), working capital is another key measure of liquidity. Defined as current assets minus current liabilities, the greater the amount of working capital, the more likely a firm has enough liquidity to meet current obligations.
- Debt-to-equity ratio. Divide total liabilities by total equity (assets minus liabilities) to arrive at this ratio. This relationship is often scrutinized by financial institutions. The lower the percentage, the stronger a company's equity position. In other words, the firm isn't relying solely on debt to meet payroll or finance ongoing operations — music to the ears of lenders.