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.
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.
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.
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 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.
These offer
measurements for the evaluation of
A.business
performance
B.iquidity
(short term and long term)
C.efficiency.
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.
....
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).
-
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 %
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.
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.
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.
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.
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?
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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 |
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. |
Income Statement Worksheet |
||||
| |
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 |
|
|
|
|