What Are the Three Most Important Accounting Ratios?

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    Current Ratio

    • The current ratio is possibly the most commonly used ratio in finance and accounting. You can calculate this figure by dividing current assets by current liabilities, both of which are outlined in the firm's balance sheet. Current assets are those that can be turned into cash in less than 12 months. They include cash, marketable securities and collectibles that are due in less than one year. Current liabilities, on the other hand, include all financial obligations that must be met within the next 12 months.
      At the minimum, analysts want to see a current ratio exceeding one. This means that the firm can meet its obligations with the easily accessible resources at its disposal. To account for unforeseen circumstances, however, a current ratio of at least two is preferable.

    Inventory Turnover

    • The inventory turnover ratio equals annual sales divided by inventory levels. This figure tells the analyst how many times the firm is turning over its inventories during the average year. A ratio of six, for instance, would imply that the firm is selling the amount of goods in storage six times per year, or depleting and replenishing inventories every two months, on average.
      High inventories mean money tied up in stock, as well as storage costs and potential spoilage/aging of goods. Therefore, the lower this ratio, the better, provided that stocks are not so low that the firm is unable to meet sudden, large orders.

    Debt to Equity

    • The debt to equity ratio is used to assess the balance between internal and external financial resources of the firm. Analysts calculate this ratio by dividing long-term debt by stockholders' equity. The larger the ratio, the heavier the firm's reliance on debt, as opposed to shareholder equity. At what level this ratio indicates excessive use of debt depends on the firm's profitability and long-term growth potential. Highly profitable firms in the midst of a growth spurt borrow heavily and have no problem paying their debt. A corporation with little potential for growth and lackluster profitability, on the other hand, can get into trouble if it uses too much debt.

    Other Metrics

    • Additional ratios often utilized by financial professionals include receivable turnover ratio, which indicates how much of the firm's sales are on credit; net profit margin, which shows what percentage of sales the company can turn into net income; return on equity, which is a measure of how effectively the firm is using the assets entrusted by shareholders; and earnings per share, which is a quick way of checking whether the firm's stock is over- or under-priced.

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