🏥 Financial Health Ratios: Your Company’s Doctor’s Report
Imagine you’re a doctor, but instead of checking a person’s health, you’re checking a company’s health. Just like a doctor uses a thermometer, blood pressure cuff, and stethoscope, you use financial ratios to see if a business is healthy, sick, or somewhere in between.
Let’s meet our patient: Tommy’s Toy Store 🧸
🩺 The Health Check Begins
Think of a company like a piggy bank with legs. It walks around, buys things, sells things, and tries to grow bigger. But how do we know if it’s doing well?
We look at special numbers called Health Ratios. These ratios tell us:
- Can the company pay its bills? 💰
- Is it borrowing too much money? 📊
- Is it using its stuff wisely? 🔧
1️⃣ Current Ratio: “Can I Pay My Bills THIS MONTH?”
The Story
Imagine you have $10 in your pocket and your friend says you owe them $5 for ice cream. Can you pay? YES! You have more money than you owe.
The Formula
Current Ratio = Current Assets ÷ Current Liabilities
Current Assets = Money and things you can turn into money quickly (cash, stuff people owe you, inventory)
Current Liabilities = Bills you need to pay soon
🎯 Example: Tommy’s Toy Store
- Current Assets: $50,000 (cash + toys to sell)
- Current Liabilities: $25,000 (bills due this month)
Current Ratio = $50,000 ÷ $25,000 = 2.0
What does 2.0 mean? Tommy has $2 for every $1 he owes. That’s HEALTHY!
📏 The Rule
| Ratio | What It Means |
|---|---|
| Below 1 | 😰 Uh-oh! Can’t pay bills |
| 1 to 1.5 | 😐 Just okay, be careful |
| 1.5 to 3 | 😊 Healthy! |
| Above 3 | 🤔 Maybe not using money wisely |
2️⃣ Quick Ratio: “What If I Can’t Sell My Stuff?”
The Story
The Current Ratio counts everything, including toys on the shelf. But what if nobody wants to buy those toys? The Quick Ratio is stricter—it only counts money you can grab RIGHT NOW.
It’s like asking: “If you couldn’t sell your toys, could you still pay your friend?”
The Formula
Quick Ratio = (Cash + Money Owed to You) ÷ Current Liabilities
We SKIP inventory (the toys) because selling takes time.
🎯 Example: Tommy’s Toy Store
- Cash: $15,000
- Money customers owe: $10,000
- Current Liabilities: $25,000
Quick Ratio = ($15,000 + $10,000) ÷ $25,000 = 1.0
What does 1.0 mean? Tommy can JUST barely pay his bills without selling any toys. That’s okay, but not much breathing room!
📏 The Rule
| Ratio | What It Means |
|---|---|
| Below 0.5 | 😰 Danger zone |
| 0.5 to 1 | 😐 Careful! |
| 1+ | 😊 Safe |
3️⃣ Debt-to-Equity Ratio: “Am I Borrowing Too Much?”
The Story
Imagine you want to buy a bicycle that costs $100. You have two choices:
- Use your own $100 (Equity = Your own money)
- Borrow $100 from your parents (Debt = Borrowed money)
If you use half-and-half ($50 yours, $50 borrowed), your debt-to-equity is 1:1.
The Formula
Debt-to-Equity = Total Debt ÷ Shareholders' Equity
🎯 Example: Tommy’s Toy Store
- Total Debt: $80,000 (loans from bank)
- Shareholders’ Equity: $100,000 (owner’s money)
Debt-to-Equity = $80,000 ÷ $100,000 = 0.8
What does 0.8 mean? For every $1 of Tommy’s own money, he borrowed $0.80. That’s reasonable!
📏 The Rule
| Ratio | What It Means |
|---|---|
| Below 1 | 😊 Using mostly own money |
| 1 to 2 | 😐 Balanced |
| Above 2 | 😰 Heavy on borrowed money |
4️⃣ Debt-to-Assets Ratio: “How Much of My Stuff Is Actually Mine?”
The Story
You have a toy chest worth $200. But you borrowed $50 to buy some toys. How much of that chest is REALLY yours?
The Debt-to-Assets ratio tells us what percentage of a company’s stuff was bought with borrowed money.
The Formula
Debt-to-Assets = Total Debt ÷ Total Assets
🎯 Example: Tommy’s Toy Store
- Total Debt: $80,000
- Total Assets: $180,000
Debt-to-Assets = $80,000 ÷ $180,000 = 0.44 (or 44%)
What does 44% mean? 44% of Tommy’s stuff was bought with borrowed money. 56% is truly his!
📏 The Rule
| Ratio | What It Means |
|---|---|
| Below 0.4 | 😊 Low debt, very safe |
| 0.4 to 0.6 | 😐 Moderate |
| Above 0.6 | 😰 High debt, risky |
5️⃣ Interest Coverage Ratio: “Can I Pay My Loan Interest?”
The Story
When you borrow money, you pay back MORE than you borrowed. That extra part is called interest. It’s like a “thank you” fee to the lender.
This ratio asks: “Do I make enough money to pay that thank you fee?”
The Formula
Interest Coverage = Operating Income ÷ Interest Expense
Operating Income = Money earned from running the business
🎯 Example: Tommy’s Toy Store
- Operating Income: $30,000
- Interest Expense: $6,000 per year
Interest Coverage = $30,000 ÷ $6,000 = 5.0
What does 5.0 mean? Tommy earns 5 times more than he needs to pay interest. Super safe!
📏 The Rule
| Ratio | What It Means |
|---|---|
| Below 1 | 😰 Can’t pay interest! |
| 1 to 2 | 😐 Barely managing |
| 2 to 5 | 😊 Comfortable |
| Above 5 | 🎉 Very safe |
6️⃣ Asset Turnover Ratio: “Am I Using My Stuff Wisely?”
The Story
Imagine you have a lemonade stand worth $100. If you sell $200 of lemonade in a year, you “turned over” your assets 2 times!
It’s like asking: “How hard is my stuff working for me?”
The Formula
Asset Turnover = Revenue ÷ Total Assets
🎯 Example: Tommy’s Toy Store
- Revenue (Sales): $360,000 per year
- Total Assets: $180,000
Asset Turnover = $360,000 ÷ $180,000 = 2.0
What does 2.0 mean? Every dollar of Tommy’s stuff generates $2 in sales. Great efficiency!
📏 The Rule
| Industry | Good Ratio |
|---|---|
| Retail stores | 2.0 - 3.0 |
| Manufacturing | 1.0 - 2.0 |
| Tech companies | 0.5 - 1.0 |
Different businesses have different “normal” speeds!
7️⃣ Inventory Turnover: “How Fast Do I Sell My Products?”
The Story
Imagine you have a bowl of 10 apples. If you sell all 10 and refill the bowl 12 times in a year, your inventory turnover is 12!
Fast turnover = Fresh products, happy customers Slow turnover = Old stuff sitting on shelves
The Formula
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
🎯 Example: Tommy’s Toy Store
- Cost of Goods Sold: $240,000
- Average Inventory: $20,000
Inventory Turnover = $240,000 ÷ $20,000 = 12
What does 12 mean? Tommy sells and restocks his entire inventory 12 times a year (once per month). Perfect for a toy store!
📏 The Rule
| Turnover | What It Means |
|---|---|
| Very Low (2-4) | 😰 Slow sales, old stock |
| Moderate (5-8) | 😐 Average |
| High (10+) | 😊 Fast-moving products |
8️⃣ Receivables Turnover: “How Fast Do Customers Pay Me?”
The Story
Sometimes customers say “I’ll pay you later.” Those IOUs are called receivables.
If customers take forever to pay, you’re waiting for YOUR money. That’s not good!
The Formula
Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
🎯 Example: Tommy’s Toy Store
- Net Credit Sales: $120,000 (sales on credit)
- Average Accounts Receivable: $10,000
Receivables Turnover = $120,000 ÷ $10,000 = 12
What does 12 mean? Tommy collects his IOUs 12 times a year. That means customers pay in about 30 days (365 ÷ 12 = 30 days). That’s quick!
Days to Collect
Days = 365 ÷ Receivables Turnover
365 ÷ 12 = 30 days
📏 The Rule
| Days to Collect | What It Means |
|---|---|
| Under 30 days | 😊 Fast! Great |
| 30-45 days | 😐 Normal |
| Over 60 days | 😰 Slow, watch out |
🗺️ The Complete Health Check Map
graph TD A[💰 Financial Health Check] --> B[Can Pay Bills?] A --> C[Borrowing Too Much?] A --> D[Using Assets Well?] B --> B1[Current Ratio] B --> B2[Quick Ratio] B --> B3[Interest Coverage] C --> C1[Debt-to-Equity] C --> C2[Debt-to-Assets] D --> D1[Asset Turnover] D --> D2[Inventory Turnover] D --> D3[Receivables Turnover]
🎯 Quick Summary Table
| Ratio | Formula | Good Sign |
|---|---|---|
| Current | Assets ÷ Liabilities | > 1.5 |
| Quick | (Cash + Receivables) ÷ Liabilities | > 1.0 |
| Debt-to-Equity | Debt ÷ Equity | < 1.0 |
| Debt-to-Assets | Debt ÷ Assets | < 0.5 |
| Interest Coverage | Income ÷ Interest | > 3.0 |
| Asset Turnover | Revenue ÷ Assets | Varies |
| Inventory Turnover | COGS ÷ Inventory | High |
| Receivables Turnover | Sales ÷ Receivables | High |
🌟 The Big Picture
Think of these 8 ratios as 8 vital signs, just like a doctor checks:
- Heart rate → Current & Quick Ratio (can you keep going?)
- Blood pressure → Debt Ratios (too much pressure?)
- Fitness level → Turnover Ratios (how efficient are you?)
A healthy company passes ALL these checks. One bad ratio is a warning sign. Multiple bad ratios? Time for treatment!
🎮 You’re Now a Financial Doctor!
You’ve learned to: ✅ Check if a company can pay its short-term bills ✅ Measure how much a company borrows ✅ See how efficiently a company uses its resources ✅ Spot warning signs before they become problems
Next time you hear about a company, you can ask: “But what are their health ratios?” And you’ll know EXACTLY what to look for!
Remember: Ratios are like puzzle pieces. One ratio alone doesn’t tell the whole story. Put them ALL together to see the complete picture of a company’s health! 🧩