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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 lower 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