Forms of Ratios

A ratio is any value resulting from the comparison between two or more related values. In this book, the term ratio is applied liberally to many formulas and calculations that, strictly speaking, are not ratios. However, for the purpose of maintaining a focus on the desired result, all of these processes are called ratios. Any time the result is expressed in an abbreviated form it will be called a ratio.

There are four methods for expressing ratios. They are:

1.     Dollar amount. An abbreviated expression in the form of dollar value is one popular method for expressing ratio values. It is applicable only when dealing with financial information in comparison with some other value, and when the result makes sense as a dollar value. For example, earnings per share is always expressed as a dollar value. The overall earnings (net profit) represents the total earnings for the entire corporation. When that is divided by the number of outstanding shares of common stock, the result is per-share earnings, or a dollar amount.

2.    Percentage. The use of percentages to express financial value is one of the most popular and widely used methods of communicating. Financial statements often contain percentage expressions, especially on the statement of income. One form of expression even provides for the exclusive use of percentages in place of dollar amounts. Thus, the abbreviated form of the statement of income would appear as:

Total sales                  100.00%

Cost of sales                   61.32

Gross profit                    38.68%

Expenses                        27.94

Net profit                     10.74%

Percentages are used in a variety of other ratios, notably those comparing one dollar amount to another (profit to sales, bonds to total capitalization, and so forth).

3.     Value x to value y. The shorthand version of the ratio is used for ratios such as the current ratio, where one group of dollar amounts is compared to another. The minimum standard normally requires a current ratio of 2-to-l, also expressed as 2/1. The x to у format breaks down dollar values in a way that is readily comprehended at a glance and that makes it easy to compare results from year to year.

4.     The number of times or occurrences. Many ratios involve studying the number of times an event occurs. For example, when a ratio demonstrates the number of times inventory is turned over (sold and replaced), the result is expressed as the number of times that happens. So when you see a turnover of 7 versus previous turnover rates of 4 or 5, that is a significant slowdown. (More on turnover below.)

If you develop a ratio on your own, you should select the expression that most aptly fits with the information you are studying. If you prefer one method over another and you believe it provides you with better insight about what the numbers reveal, you should change even a standard method to suit your own needs.