Financial Ratio Analysis

The Balance Sheet and the Statement of Income are essential, but they are only the starting point for successful financial management. Apply Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business.

Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors' funding). They include the following ratios:

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.

Current Ratios. The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:

                        Total Current Assets
Current Ratio = ____________________
                        Total Current Liabilities

The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.

If you decide your business's current ratio is too low, you may be able to raise it by:

Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is figured as shown below:

                        Cash + Government Securities + Receivables
Quick Ratio = _________________________________________
                                    Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.

Working Capital. Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements.

A  general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are relying to any significant extent on creditor money to finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner's equity):

                               Total Liabilities
Debt/Worth Ratio = _______________
                                 Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows:

                                    Gross Profit
Gross Margin Ratio = _______________
                                     Net Sales

(Gross Profit = Net Sales - Cost of Goods Sold)

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company's "return on sales" with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:

                                        Net Profit Before Tax
Net Profit Margin Ratio = _____________________
                                              Net Sales

Management Ratios

Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:

                                                        Net Sales
Inventory Turnover Ratio = ___________________________
                                          Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is calculated as follows:

Net Credit Sales/Year
__________________ = Daily Credit Sales
365 Days/Year

                                                                  Accounts Receivable
Accounts Receivable Turnover (in days) = _________________________
                                                                   Daily Credit Sales

Return on Assets Ratio

This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows:

                                   Net Profit Before Tax
Return on Assets = ________________________
                                     Total Assets

Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows:

                                      Net Profit before Tax
Return on Investment = ____________________
                                           Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business's relative strengths and weaknesses.

Common Ratios

The following are a list of common ratios and their definitions:

Ratio Name

Formula

Current Ratio

Current Assets / Current Liabilities - Indicates the ability of a company to pay its short term creditors from its resources of current assets therefore indicating fixed assets will remain intact
Liquidity Ratio or Acid Test Current Assets minus Stock / Current Liabilities - Indicates the ability of a company to pay its debts as they fall due. This ratio is generally considered to be a more accurate assessment of a company's health than the current ratio as it reduces the risk of relying on a ratio which may include slow moving or redundant stock. A ratio of less than 0.7 to 1 could mean danger, but in some industries the norm is 0.3 to 1.
Asset Turnover Turnover / Net Assets - Shows how fully the company is using its capital and how many pounds of turnover is generated by each pound of investment.
Collection Period Debtors x 365 / Turnover - Measures the length of time a company takes to pay its debts therefore assessing the effectiveness of the company's credit control department.
Creditor Days Creditors x 365 days / Turnover - Measures the length of time a company takes to pay its creditors.

Working Capital

Current Assets - Current Liabilities.
Gearing Long term Liabilities + Overdrafts x 100 / Shareholders Funds - Shows the ratio between company's permanent capital Shareholders' funds and reserves) and the total value of loans made to it. The higher the gearing the greater the proportion of borrowed money to "own" money. A highly geared company will have greater vulnerability if there is a sudden fall in profits as interest has to be paid regardless and also if there is a sharp rise in interest rates.
Credit Gearing Credit Limit x 100 / Shareholders Funds.
Capital Employed/Employees Total Assets - Total Liabilities / Employees.
Current Debt Current Liabilities / Shareholders Funds.
Insolvency Ratio Shareholders Funds / Loss.
Long Term Debt Long term Liabilities / Total Assets - Current Liabilities. - Shows what proportion of permanent capital has been provided by long term debt.
Profit Margin Profit before Tax x 100 / Turnover - Measures the margin of profitability on sales throughout the trading year and will vary from industry to industry. The percentage should be relatively constant and any changes investigated. Reasons for changes could be reduced selling price or increase in the cost of sales.

Profit/Employees

Profit / Employees - All employee ratios show the productivity of the company's employees and can be of value if yearly fluctuations are examined within the same industry type.
Profit/Capital Employed Profit before Tax x 100 / Total Assets - Indicates whether or not a company is generating adequate profits in relation to the resources invested in it.
Return on Shareholders Funds Profit before Tax x 100 / Shareholders Funds - Indicates whether or not a company is generating adequate profits in relation to the resources invested in it.
Shareholder Liquidity Shareholders Funds / Long Term Liabilities - Shows how many pounds worth of Shareholders' Funds exist for every pounds worth of long term debt.
Solvency Ratio percent Shareholders Funds x 100 / Total Assets - Indicates a possible over dependency on outside sources for long term financial support.
Stock Financing Stock and Work in Progress / Current Assets - Current Liabilities - Compares stock and work in progress to working capital and therefore shows how sensitive working capital is to a fall in stock values.
Stock/Turnover Turnover / Stock - Measures the number of times stock is converted into sales during the year. It must be borne in mind that different industries would have a different rate of stock turnover.

 

 

 

Ratio Analysis

Ratio analysis should not be taken in isolation of other aspects of a business. What type of business is it? A company's debtor day indicator (how long on average it takes debtors to settle bills) may be 29 days. This seems fine but not for fast-food business. Ratios must be seen against

As a principle, accounting policies should be applied consistently. Changes must be highlighted and the impact of changes from an original policy disclosed. This applies when calculating and interpreting ratios. Trends in a company's performance cannot be determined if published accounting data is dressed up so as to produce more favourable outcomes. Yet benchmark comparisons against other companies in a sector may be difficult given the flexible scope offered by Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs).

As an example of such flexibility, under SSAP 13, Research and Development, companies may within certain limits decide to capitalise development expenditure, as an alternative to charging this expense to the P&L account. One firm may do this and by-pass the P&L account in certain years whereas another may not. This will affect performance ratios and make it difficult to conclude on how the company compares against its competitors.

Key ratios

These offer measurements for the evaluation of

A.business performance

B.iquidity (short term and long term)

C.efficiency.


A.Performance

Return on total capital employed.

Used to measure overall business efficiency in employing its resources

How to calculate

 
 
   Profit before interest and tax 
   ------------------------------                   x 100 
 Share capital + reserves + debentures 
 

Using/interpreting this ratio

o       This targets the return on capital. The figure will be set by investor expectations. Consistent failure to hit the target would indicate that it would be better selling the company and redeploying its resources elsewhere.

o       Comparisons with real interest rates in the market should account for inflation if resources could be redeployed in different economies.

o       If assets have been re-evaluated this may increase capital employed and so reduce the return ratio.

o       This ratio needs to be considered in relation to the goodwill and development expenditure of accounting policies.

Gross profit percentage

.... indicates the margin the company earns on its sales

How to calculate

Gross profit
-----------       x 100 
  Sales 

Using/interpreting this ratio

Note the effect of changes in

o       sales prices without associated changes in costs

o       sales mix. If last year a company sold 3m of cream deserts at a 12% margin, and 170,000 of catering consultancy services at a 28% margin, pulling out of cream desert sales will reduce turnover, but improve gross profit %.

o       the calculation of closing stock. Gross profit % may show up stock valuation irregularities. Gross profit = sales - cost of sales (opening stock + purchases - closing stock).

Net profit percentage

- identifies the affect of fixed and variable overheads on sales.

How to calculate

Net profit before interest and tax    
-----------------------------------      x 100 
         sales
     

Using/interpreting this ratio

It requires attention to

o       changes in the value of sales.

o       changes in the structure of overhead costs. A company that has incurred a move to newer, more costly premises will feel an adverse affect on net profit %

B.    Liquidity

Short-term Liquidity

The following are generally expressed in N to 1 terms.

Current ratio

This measures a company's capacity to cover its current liabilities as they fall due.

How to calculate

 
  Current assets 
  ------------- 
Current liabilities
 

A manufacturer normally needs a current ratio of around 2:1. More than this suggests poor resource usage and potential liquidity problems.

Quick ratio or "acid test"

This test/ratio excludes slower-moving item (stock) from current assets and pinpoints real short-term liquidity.

How to calculate

 
    Debtors + cash 
  ------------------ 
Current liabilities
 

Using/interpreting this ratio

For both current ratio and quick ratio we must be aware that

o       Low ratios may indicate liquidity problems yet some businesses/industries (supermarkets once again) operate on tight liquidity ratios.

o       high ratios look good but may pinpoint poor management of funds. Cash mountains may not offer the returns that shareholders are looking for.

o       If we examine the make-up of the ratio we may find high stock levels. This may give a healthy current ratio but stock obsolescence may be evident affecting real stock valuations.

Long-term Liquidity

Gearing ratio

There are several variations but the general gearing ratio measures the relationship between a firm's borrowings and its shareholders' funds.

How to calculate

Fixed return capital (debentures, preference shares, loan stock
     --------------------------------------------------
        Equity capital + reserves
        

Using/interpreting this ratio

Note:

o       company cash flow stability. Strongly branded business can rely on stable cash flows. Such a company can borrow heavily against its brands/labels in order to fund acquisitions/expansion etc.

o       policies to revaluate fixed assets may improve shareholders' funds and reduce gearing are popular as they avoid breaches of covenants when raising additional debt.

C.    Efficiency Ratios

Stock turnover

This measures a company's effectiveness in converting stock into sales. So long as a sale involves a profit then the faster the company turns its stock over, the more it makes.

How to calculate

cost of sales            closing stock 
 -----------     or       ------------         x 365 
closing stock            cost of sales  

Closing stock is better than average stock for comparisons unless we have data from several years.

Using/interpreting this ratio

o       low turnover may point to obsolete stock though some businesses/industries may need high stocks or carry high-value, slow-moving items. Higher gross profit %s in these cases may compensate for lower stock turn.

o       high stock turn may indicate efficient management but stock-outs may occur affecting the quality of customer service.

Debtor days

This indicates the period of credit taken by the company's customers.

How to calculate

Closing debtors
--------------    x 365
 Credit sales
 

Using/interpreting this ratio

o       an increase over the previous year may be due to bad debt problems but it may also indicate a change in a company's change settlement terms policy.

o       the customer base may have changed, important new customers demanding longer settlement terms

o       we should evaluate whether or not year_end debtors are representative of the year as a whole? If we stock up ahead of a sales drive just before year_end, a distorted pattern may result.

Creditor days

This measures the credit period a company takes from its suppliers

How to calculate

Trade creditors
---------------    x 365
Credit purchases
 

Using/interpreting this ratio

o       high figures suggest liquidity problems (financing the business on the backs of its suppliers. Examine the company's overdraft position. Has it has run out of bank facilities?

o       Is a potential receivership on the cards? Are creditors losing patience?

o       Does the ratio reflect the year as a whole?

Using the Ratios

You need to be able to

        calculate the ratios

        interpret your findings

        make suggestions.

In many cases the constituent parts of a ratio must be examined to cast light on

        movement, trends

        priorities and significant influences

        implications. Is an adverse ratio a blip or a long term, worrying trend?

        the ratio result set against the industry norms and relationships with other ratios

 

 

 

 

 

 

BALANCE SHEET RATIOS

Ratio

How to Calculate

What it Means In Dollars and Cents

Current

Current Assets
Current Liabilities

Measures solvency: The number of dollars in Current Assets for every$1 in Current Liabilities.

For example: a Current Ratio of 1.76 means that for every $1 of Current Liabilities, the company has $1.76 in Current Assets with which to pay them

Quick

Cash + Accounts Receivable Current Liabilities

Measures liquidity: The number of dollars in Cash and Accounts Receivable for each $1 in Current Liabilities. For example: a Quick Ratio of 1.14 means that for every $1 of Current Liabilities, the company has $1.14 in Cash and Accounts Receivable with which to pay them.
Cash

Cash
Current Liabilities

Measures liquidity more strictly: The number of dollars in Cash for every $1 in Current Liabilities.

*For example: a Cash Ratio of 0.17 means that for every $1 of Current Liabilities, the company has $0.17 in Cash with which to pay them.

Debt-to-Worth

Total Liabilities
Net Worth

Measures financial risk: The number of dollars of Debt owed for every $1 in Net Worth.

*For example: a Debt-to-Worth Ratio of 1.05 means that for every $1 of Net Worth that the owners have invested, the company owes $1.05 of debt to its creditors.

 

INCOME STATEMENT RATIOS

Ratio

How to Calculate

What it Means In Dollars and Cents

Gross Margin

Gross Margin
Sales

Measures profitability at the Gross Profit level: The number of dollars of Gross Margin produced for every $1 of Sales.

*For example: a Gross Margin Ratio of 34.4% means that for every $1 of Sales, the company produces 34.4 cents of Gross Margin.

Net Margin

Net Profit Before Tax
Sales

Measures profitability at the Net Profit level: The number of dollars of Net Profit produced for every $1 of Sales.

*For example: a Net Margin Ratio of 2.9% means that for every $1 of Sales, the company produces 2.9 cents of Net Margin.

 

OVERALL EFFICIENCY RATIOS

Ratio

How to Calculate

What it Means In Dollars and Cents

Sales-to-Assets

Sales
Total Assets

Measures the efficiency of Total Assets in generating sales: The number of dollars in Sales produced for every $1 invested in Total Assets.

*For example: a Sales-to-Assets ratio of 2.35 means that for every $1 dollar invested in Total Assets, the company generates $2.35 in Sales.

Return on Assets

Net Profit Before Tax
Total Assets

Measures the efficiency of Total Assets in generating Net Profit: The number of dollars in Net Profit produced for every $1 invested in Total Assets.

*For example: a Return on Assets ratio of 7.1% means that for every $1 invested in Assets, the company is generating 7.1 cents in Net Profit Before Tax.

Return on Investment

Net Profit Before Tax
Net Worth

Measures the efficiency of Net Worth in generating Net Profit: The number of dollars in Net Profit produced for every $1 invested in Net Worth.

*For example: a Return on Investment ratio of 16.1% means that for every $1 invested in Net Worth, the company is generating 16.1 cents in Net Profit Before Tax.

 

SPECIFIC EFFICIENCY RATIOS

Ratio

How to Calculate

What it Means In Dollars and Cents

Inventory Turnover

Cost of Goods Sold
Inventory

Measures the rate at which Inventory is being used on an annual basis.

* For example: an Inventory Turnover ratio of 9.81 means that the average dollar volume of Inventory is used up almost ten times during the fiscal year.

Inventory Turn-Days

360  
Inventory Turnover

Converts the Inventory Turnover ratio into an average "days inventory on hand" figure.

*For example: a Inventory Turn-Days ratio of 37 means that the company keeps an average of thirty-seven days of Inventory on hand throughout the year.

Accounts Receivable Turnover

Sales
Accounts Receivable

Measures the rate at which Accounts Receivable are being collected on an annual basis.

*For example: an Accounts Receivable Turnover ratio of 8.00 means that the average dollar volume of Accts Receivable are collected eight times during the year.

Average Collection Period

360
A/R Turnover

Converts the Accounts Receivable Turnover ratio into the average number of days the company must wait for its Accounts Receivable to be paid.

*For example: an Accounts Receivable Turnover ratio of 45 means that it takes the company 45 days on average to collect its receivables.

Accounts Payable Turnover

Cost of Goods Sold 
Accounts Payable

Measures the rate at which Accounts Payable are being paid on an annual basis.

*For example: an Accounts Payable Turnover ratio of 12.04 means that the average dollar volume of Accounts Payable are paid about twelve times during the year.

Average Payment Period

      360       
A/P Turnover

Converts the Accounts Payable Turnover ratio into the average number of days that a company takes to pay its Accounts Payable. *For example: an Accounts Payable Turnover ratio of 30 means that it takes the company 30 days on average to pay its bills.

RATIO ANALYSIS Worksheet

 

19 __

19 __

19 __

Industry
Composite

Calculations,
Trends, or Observations


BALANCE SHEET RATIOS: Stability (or "Staying Power")
1

Current

Current Assets
Current Liabilities

 

 

 

 

 

2

Quick

Cash + Accts. Rec.
Current Liabilities

             
3

Debt-to-
Worth

Total Liabilities
Net Worth

             

INCOME STATEMENT RATIOS: Profitability (or "Earning Power")
4

Gross
Margin

Gross Profit
Sales

             
5

Net
Margin

Net Profit Before Tax
Sales

             

ASSET MANAGEMENT RATIOS: Overall Efficiency Ratios
6

Sales-to-
Assets

Sales
Total Assets

             
7

Return on
Assets

Net Profit Before Tax
Total Assets

             
8

Return on
Investment

Net Profit Before Tax
Net Worth

             

ASSET MANAGEMENT RATIOS: Working Capital Cycle Ratios
9

Inventory
Turnover

Cost of Goods Sold
Inventory

             
10

Inventory
Turn-Days

       360       
Inventory Turnover

             
11

Accounts
Receivable
Turnover

         Sales         
Accounts Receivable

             
12

Average
Collection
Period

         360         
Accts. Rec. Turnover

             
13

Accounts
Payable
Turnover

Cost of Goods Sold
Accounts Payable

             
14

Average
Payment
Period

          360          
Accts. Pay. Turnover

             

 

Balance Sheet Worksheet -- Part #1
as of ____________________ , 19 __

 

19 __

19 __

19 __

Trends

ASSETS
       
Cash

 

 

 

Accounts Receivable

 

 

 

Inventory

 

 

 

Other -- A/R officer

 

 

 

Other

 

 

 

Other

 

 

 

Total Current Assets

 

 

 

Leasehold Improvements

 

 

 

Vehicles

 

 

 

Furniture/Fixtures/Office Equip

 

 

 

Equipment

 

 

 

Buildings

 

 

 

Land

 

 

 

Accumulated Depreciation (                 ) (                 ) (                 )
Fixed Assets (net)

 

 

 

Other -- patent acquisition

 

 

 

Total Assets

 

 

 

 

Balance Sheet Worksheet -- Part #2
as of ____________________ , 19 __

 
   

19 __

19 __

19 __

Trends

 
  LIABILITIES & NET WORTH          
  Notes Payable -- bank

 

 

 

 
  Current Portion -- long-term debt

 

 

 

 
  Accounts Payable -- trade

 

 

 

 
  Accruals

 

 

 

 
  Other

 

 

 

 
  Other

 

 

 

 
  Total Current Liabilities

 

 

 

 
  Long-Term Debt

 

 

 

 
  Mortgages

 

 

 

 
  Other

 

 

 

 
  Total Long-Term Liabilities

 

 

 

 
  Total Liabilities

 

 

 

 
  Capital Stock

 

 

 

 
  Additional Paid-In Capital

 

 

 

 
  Retained Earnings

 

 

 

 
  Net Worth

 

 

 

 
  Total Liabilities and Net Worth

 

 

 

 
                     

 

 

Income Statement Worksheet
as of ____________________ , 19 __

 

19 __

19 __

19 __

Trends

Sales

 

 

 

 
  Cost of Goods Sold

 

 

 

Gross Profit

 

 

 

Expenses

 

 

 

  Salary

 

 

 

  Payroll Taxes

 

 

 

  Advertising

 

 

 

  Rent

 

 

 

  Utilities

 

 

 

  Office Supplies

 

 

 

  Insurance

 

 

 

  Bad Debts

 

 

 

  Depreciation

 

 

 

  Vehicles

 

 

 

  Accounting

 

 

 

  Travel / Entertainment

 

 

 

  Shop Supplies

 

 

 

  Taxes

 

 

 

  Other

 

 

 

  Other

 

 

 

Total Expenses

 

 

 

Operating Profit

 

 

 

  Interest (                 ) (                 ) (                 )
  Other Income

 

 

 

Net Profit Before Taxes

 

 

 

  Tax

 

 

 

Net Profit After Tax

 

 

 


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