20 Calculating Return on Investment
Learning Objectives
- Calculate and interpret liquidity ratios.
Liquidity Ratios
Liquidity ratios measure the financing that is supplied by the owners of the business versus the financing that is provided by creditors such as suppliers and banks. Leverage ratios also are indicators of the financial risk a business is exposed to. Low leverage ratios indicate that a downturn in the economy will have minimal impact on the financial position of a business. For example, if a business is funding its operations primarily through bank loans, a downturn in the economy will decrease revenues, but the business will still be responsible for payments to its creditors and lenders.
- Current Ratio. The current ratio measures a company’s ability to pay its current liabilities from its current assets.
Current Ratio= (Current Assets)/(Current Liabilities)
Generally, the higher the current ratio, the stronger the financial position of the business and typically financial analysts consider a current ratio of 2:1 to be ensure that a business has sufficient working capital to fund ongoing operations.
- Quick Ratio or Return on Investment (ROI). The quick ratio or return on investment (sometimes referred to as the acid test ratio) is more conservative than the current ratio because it does not include inventory in current assets. The quick ratio measures a company’s ability to pay its current debts if all revenue ceased.
Quick Ratio= (Current Assets — Inventory)/(Current Liabilities)
A quick ratio of 1:1 is considered satisfactory and a ratio higher than this is an indicator of greater financial security.
