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3
Now let us compare our Return on Equity to a combination of the three component

ratios:
From our example, Return on Equity = $ 60,000 / $ 320,000 or 18.75% or we can

combine
the three components of Return on Equity from our examples:
Profit Margin x Asset Turnover x Financial Leverage = Return on Equity or .125 x

.96 x 1.56 =
18.75%.
Now that we understand the basic ratio structure, we can move down to a more

detail
analysis with ratios. Four common groups of detail ratios are: Liquidity, Asset

Management,
Profitability and Leverage. We will also look at market value ratios.
Liquidity Ratios
Liquidity Ratios help us understand if we can meet our obligations over the

short-run. Higher
liquidity levels indicate that we can easily meet our current obligations. We can

use several
types of ratios to monitor liquidity.
Current Ratio
Current Ratio is simply current assets divided by current liabilities. Current

assets include
cash, accounts receivable, marketable securities, inventories, and prepaid items.

Current
liabilities include accounts payable, notes payable, salaries payable, taxes

payable, current
maturity's of long-term obligations and other current accruals.
EXAMPLE — Current Assets are $ 200,000 and Current Liabilities are $
80,000. The Current Ratio is $ 200,000 / $ 80,000 or 2.5. We have 2.5
times more current assets than current liabilities.
A low current ratio would imply possible insolvency problems. A very high current

ratio might
imply that management is not investing idle assets productively. Generally, we

want to have a
current ratio that is proportional to our operating cycle. We will look at the

Operating Cycle as
part of asset management ratios.