FINANCIAL STATEMENTS are analyzed by MANAGEMENT and investors to predict and plan for the future. Financial ratios, fractions that show relationships between accounts found on the financial statements, are the tools used in financial-statement analysis. Some ratios are useful in the analysis of a single firm, while other ratios have meaning only when compared to those of other firms or to industry averages. A few of the more common financial ratios follow. A firm’s credit worthiness—that is, its ability to service its debt on a timely basis—can be determined by the current ratio and the acid-test ratio. A rough measure of a firm’s ability to pay its debt on time is the current ratio: current ASSETS divided by current liabilities (CA/CL). The numerator is the firm’s current assets and the denominator is the firm’s current liabilities (current debt). The current assets are the firm’s resources it will use to pay its current debts. If the current assets exceed the current liabilities, the current ratio will have a value greater than 1, an indicator that there are sufficient current assets to pay the current liabilities. Thus current ratios greater than 1 indicate that a firm can take on more debt. If the current assets are equal to the current liabilities, the current ratio will have a value of 1. All of the firm’s current assets are used to cover (pay) the current liabilities, and the firm has no excess assets with which to assume additional debt. If the current assets are less than the current liabilities, the current ratio will have a value less than 1, and the firm is having problems paying its current debt. In fact, a current ratio less than 1 is indicative of a firm that is slow in paying its bills. Working CAPITAL is the current assets of a firm: cash, short-term investments, ACCOUNTS RECEIVABLE, and inventories. Net working capital (CA–CL) is a measure of a firm’s liquidity, the amount of current assets remaining after the current debt of the firm is paid. The current ratio (CA/CL) can be used to compare net working capital among firms. Included in a firm’s current assets are merchandise inventories, but in reality inventories aren’t very liquid. If a buyer is found, the sale may be a sale on credit, in which case no monies are currently received. Many creditors understand the lack of liquidity associated with inventories, and as a result they prefer using the acid-test (quick) ratio, in which inventories are not included with the current assets of the firm: (CA–inventories)/CL. Because inventories are subtracted from the current assets, the acid-test numerator is smaller than the one used in the current ratio. This causes the acid-test ratio to be a stricter measure of the debt worthiness of a firm; the acid-test ratio is more commonly than the current ratio for this purpose. The debt ratio (total liabilities/total assets) is an indicator of a firm’s capital structure. For example, a debt ratio of 60 percent indicates that debt (liabilities) comprises 60 percent of a firm’s capital and EQUITY (stocks) comprises 40 percent. The days’ sales outstanding (DSO) ratio (accounts receivable/average sales per day) analyzes a firm’s accounts receivable by determining its average collection period, the average number of days a firm waits after making a credit sale before receiving cash. The number of days’ sales tied up in accounts receivable is compared with that of other firms or with industry averages to determine how well a firm manages its investment in accounts receivable. The asset-turnover ratio (sales/total assets) measures a firm’s sales volume relative to its INVESTMENT in total assets. For example, a firm with an asset-turnover ratio of 1.4 times operating in an industry with an industry average of 1.7 times is not generating sufficient sales volume, given its investment in total assets. The price/earnings (P/E) ratio (price per share/earnings per share) indicates how much investors are willing to pay per dollar of current earnings. When compared to industry averages, a low P/E ratio generally indicates that investors view the firm as being riskier than other firms in its industry. A high P/E ratio relative to the industry average generally indicates that investors view this firm as having a greater potential for growth and, therefore, less riskier. PROFIT margin is the relationship between a firm’s net INCOME and its sales volume, indicated by the profitmargin ratio (net income/sales). This ratio measures a firm’s income per dollar of sales. A firm’s relative profitability can be determined by comparing its profit margin ratio with that for the industry. Return on equity (ROE), the ratio of net income to common equity, measures the rate of return earned by the common stockholders’ investment in a firm. The ROE ratio is net income/total common equity. In order for a firm to attract the interest of investors and thus retain their investment in the firm, its ROE must be greater than or equal to its industry average. A firm with a low ROE as compared to its industry average will be viewed by investors as an unattractive investment, and investors will be attracted to those firms with greater earnings potential.