Financial Ratios
Financial ratios are a valuable and easy way to interpret the numbers
found in statements. It can help to answer critical questions such as
whether the business is carrying excess debt or inventory, whether customers
are paying according to terms, whether the operating expenses are too
high and whether the company assets are being used properly to generate
income.
When computing financial relationships, a good indication of the company's
financial strengths and weaknesses becomes clear. Examining these ratios
over time provides some insight as to how effectively the business is
being operated.
Many industries compile average industry ratios each year. Average
industry ratios offer the small business owner a means of comparing
his or her company with others within the same industry. In this manner,
they provide yet another measurement of an individual company's strengths
or weaknesses. Robert Morris & Associates is a good source of comparative
financial ratios. Following are the most critical ratios for most businesses,
though there are others that may be computed.
Note: There may be different ways to compute ratios. It is
important to be consistent from year to year and use the same method
when making comparisons. FisCAL calculates ratios the same way as Robert
Morris Associates (RMA).
1. Liquidity
Liquidity measures a company's capacity to pay its debts as they
come due. There are two ratios for evaluating liquidity.
Current Ratio: The current ratio gauges how
capable a business is in paying current liabilities by using current
assets only. Current ratio is also called the working capital ratio.
A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or
2/1). However, an industry average may be a better standard than this
rule of thumb. The actual quality and management of assets must also
be considered.
The formula is:
Total Current Assets
_____________________
Total Current Liabilities
Quick Ratio: Quick ratio focuses on immediate liquidity (i.e.,
cash, accounts receivable, etc.) but specifically ignores inventory.
Also called the acid test ratio, it indicates the extent to which
you could pay current liabilities without relying on the sale of inventory.
Quick assets are highly liquid and are immediately convertible to
cash. A general rule of thumb states that the ratio should be 1 to
1 (or 1:1 or 1/1).
The formula is:
Cash + Accounts Receivable
( + any other quick assets )
_____________________
Current Liabilities
2. Safety
Safety indicates a company's vulnerability to risk, e.g., the degree
of protection provided for the business' debt. Three ratios help you
evaluate safety.
Debt to Equity: Debt to equity is also called debt
to net worth. It quantifies the relationship between the capital invested
by owners and investors and the funds provided by creditors. The higher
the ratio, the greater the risk to a current or future creditor. A
lower ratio means your client's company is more financially stable
and is probably in a better position to borrow now and in the future.
However, an extremely low ratio may indicate that your client is too
conservative and is not letting the business realize its potential.
The formula is:
Total Liabilities (or Debt)
_____________________
Net Worth (or Total Equity)
EBIT/Interest: This assesses the company's ability
to meet interest payments. It also evaluates the capacity to take
on more debt. The higher the ratio, the greater the company's ability
to make its interest payments or perhaps take on more debt.
The formula is:
Earnings Before Interest & Taxes
________________________
Interest Charges
Cash Flow to Current Maturity of Long-Term
Debt: Indicates how well traditional cash flow (net profit
plus depreciation) covers the company's debt principal payments
due in the next 12 months. It also indicates if the company's cash
flow can support additional debt.
The formula is:
Net Profit + Non-Cash Expenses*
__________________________
Current Portion of Long-term Debt
*Such as depreciation, amortization and depletion.
3. Profitability
Profitability ratios measure the company's ability to generate a
return on its resources. Use the following four ratios to help your
client answer the question, "Is my company as profitable as it should
be?" An increase in the ratios is viewed as a positive trend.
Gross Profit Margin: Gross profit margin indicates
how well the company can generate a return at the gross profit level.
It addresses three areas -- inventory control, pricing and production
efficiency.
The formula is:
Gross Profit
____________
Total Sales
Net Profit Margin: Net profit margin shows how much
net profit is derived from every dollar of total sales. It indicates
how well the business has managed its operating expenses. It also
can indicate whether the business is generating enough sales volume
to cover minimum fixed costs and still leave an acceptable profit.
The formula is:
Net Profit
_____________
Total Sales
Return on Assets: This evaluates how
effectively the company employs its assets to generate a return. It
measures efficiency.
The formula is:
Net Profit Before Taxes
_____________________
Total Assets
Return on Equity: This is also called return on investment
(ROI). It determines the rate of return on the invested capital. It
is used to compare investment in the company against other investment
opportunities, such as stocks, real estate, savings, etc. There should
be a direct relationship between ROI and risk (i.e., the greater the
risk, the higher the return).
The formula is:
Net Profit Before Taxes
_____________________
Net Worth
4. Efficiency
Efficiency evaluates how well the company manages its assets. Besides
determining the value of the company's assets, you and your client
should also analyze how effectively the company employs its assets.
You can use the following ratios:
Accounts Receivable Turnover: This ratio shows the
number of times accounts receivable are paid and reestablished during
the accounting period. The higher the turnover, the faster the business
is collecting its receivables and the more cash the client generally
has on hand.
The formula is:
Total Net Sales
_____________________
Accounts Receivable
Accounts Receivable Collection Period:
This reveals how many days it takes to collect all accounts receivable.
As with accounts receivable turnover (above), fewer days means the
company is collecting more quickly on its accounts.
The formula is:
365 Days
_____________________
Accounts Receivable Turnover
Accounts Payable Turnover: This ratio
shows how many times in one accounting period the company turns over
(repays) its accounts payable to creditors. A higher number indicates
either that the business has decided to hold on to its money longer
or that it is having greater difficulty paying creditors.
The formula is:
Cost of Goods Sold
___________________
Accounts Payable
Days Payable: This ratio shows how many days it takes
to pay accounts payable. This ratio is similar to accounts payable
turnover (above.) The business may be losing valuable creditor discounts
by not paying promptly.
The formula is:
365 days
_____________________
Accounts Payable Turnover
Inventory Turnover: This ratio shows
how many times in one accounting period the company turns over (sells)
its inventory and is valuable for spotting under-stocking, overstocking,
obsolescence and the need for merchandising improvement. Faster turnovers
are generally viewed as a positive trend; they increase cash flow
and reduce warehousing and other related costs.
The formula is:
Cost of Goods Sold
________________
Inventory
Days Inventory: This ratio identifies the average length
of time in days it takes the inventory to turn over. As with inventory
turnover (above), fewer days mean that inventory is being sold more
quickly.
The formula is:
365 Days
_________________
Inventory Turnover
Sales to Net Worth: This volume ratio
indicates how many sales dollars are generated with each dollar of
investment (net worth).
The formula is:
Total Sales
____________
Net Worth
Sales to Total Assets: This indicates
how efficiently the company generates sales on each dollar of assets.
A volume indicator, this ratio measures the ability of the company's
assets to generate sales.
The formula is:
Total Sales
_____________
Total Assets
Debt Coverage Ratio:
This is an indication of the company's ability to satisfy its debt
obligations and its capacity to take on additional debt without impairing
its survival.
The formula is:
Net Profit + Any Non-Cash Expenses
__________________________
Principal on Debt
Authored by: SBDC
Counseling Committee, SBDC Finance Committee, SBDC Marketing Committee
and The Florida SBDC
Source: MO
SBDC Professional Development Manual
Copyright ©: Curators of the University of Missouri
