Importance of Ratios

• Ratios analyzing cash resources are crucial, because a company must generate sufficient cash from operations to pay its bills. Even if the company appears to be profitable, if it does not generate adequate cash, it faces bankruptcy. For instance, if a company sells products on credit to customers who are poor credit risks, it now has receivables and appears to have generated a profit. However, if the customers do not pay for the products, the company may ultimately run out of cash, and could go bankrupt.
  
  

Calculating Ratios

• The current ratio and the quick ratio are also cash-related calculations commonly used in ratio analysis. The current ratio is calculated by dividing current assets by current liabilities. An asset or liability convertible to cash or payable within the year is categorized as current. To calculate the quick ratio, subtract inventory from current assets, then divide by current liabilities. The quick ratio is more conservative, since actual prices of inventory sold may not match values on the balance sheet. Timing of sales could be variable, as well. Finally, the cash ratio is the most conservative. It includes only actual cash and marketable securities, and then divides this sum by current liabilities.
  
  

Comparing Ratios

• The usefulness of the cash ratio and its counterparts, the current and quick ratios, may depend on the type of business. For example, using the current ratio for a company with inventory that is easily sold and not prone to obsolescence may provide an accurate gauge of solvency. For a company with slow-moving, quickly outdated inventory, the quick or cash ratios might provide better insight. Research a company's business and industry conditions to determine the appropriate ratios to use. Also remember to compare company ratios over several accounting periods, to spot trends indicating profitability and solvency.
  
  

Industry Averages

• Comparing ratios with other businesses in the same industry may provide a better indication of a company's potential than comparing ratios among different industries. For instance, manufacturing firms may only have enough cash on hand to pay current bills, while a financial transaction business may have large cash balances. Comparing the cash ratios of these two types of firms may not indicate which company would be a better investment. Comparing cash ratios from similar firms is more appropriate.
  
  

Considerations

• Although ratios may be quick gauges of a company's financial situation, ratios alone do not tell the whole story of a business' investment potential. Before investing your money, do a thorough study of the financial statements, including the notes, and consider the overall company and industry outlook.