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 Formula

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:

 Paying some debts.

 Increasing your current assets from loans or other borrowings with a maturity of
more than one year.
 Converting non-current assets into current assets.
 Increasing your current assets from new equity contributions.
 Putting profits back into the business.
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.
Vertical analysis reports each amount on a financial statement as a percentage of another item.
For example, the vertical analysis of the balance sheet means every amount on the balance sheet
is restated to be a percentage of total assets. If inventory is $100,000 and total assets are
$400,000 then inventory is presented as 25 ($100,000 divided by $400,000). If cash is $8,000
then it will be presented as 2 ($8,000 divided by $400,000). The total of the assets will now add
up to 100. If the accounts payable are $88,000 they will be presented as 22 ($88,000 divided by
$400,000). If owner’s equity is $240,000 it will be presented as 60 ($240,000 divided by
$400,000). The restated amounts from the vertical analysis of the balance sheet will be presented
as a common-size balance sheet. A common-size balance sheet allows you to compare your
company’s balance sheet to another company’s balance sheet or to the average for its industry.

Vertical analysis of an income statement results in every income statment amount being
presented as a percentage of sales. If sales were $1,000,000 they would be restated to be 100
($1,000,000 divided by $1,000,000). If the cost of goods sold is $780,000 it will be presented as
78 ($780,000 divided by sales of $1,000,000). If interest expense is $50,000 it will be presented
as 5 ($50,000 divided by $1,000,000). The restated amounts are known as a common-size
income statement. A common-size income statement allows you to compare your company’s
income statement to another company’s or to the industry average.

Horizontal analysis looks at amounts on the financial statements over the past years. For
example, the amount of cash reported on the balance sheet at December 31 of 2006, 2005, 2004,
2003, and 2002 will be expressed as a percentage of the December 31, 2002 amount. Instead of
dollar amounts you might see 134, 125, 110, 103, and 100. This shows that the amount of cash at
the end of 2006 is 134% of the amount it was at the end of 2002. The same analysis will be done
for each item on the balance sheet and for each item on the income statement. This allows you to
see how each item has changed in relationship to the changes in other items. Horizontal analysis
is also referred to as trend analysis.

Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis.

Vertical Analysis and Common Size

Statements:
Vertical analysis is the procedure of preparing and presenting common size statements.
Common size statement is one that shows the items appearing on it in percentage form
as well as in dollar form.

Each item is stated as a percentage of some total of which that item is a part. Key financial
changes and trends can be highlighted by the use of common size statements.

Common size statements are particularly useful when comparing data from different
companies. For example, in one year, Wendy's net income was about $110 million, whereas
McDonald's was $1,427 million. This comparison is somewhat misleading because of the
dramatically different size of the two companies. To put this in better perspective, the net
income figures can be expressed as a percentage of the sales revenues of each company,
Since Wendy's sales revenue were $1,746 million and McDonald's were $9,794 million,
Wendy's net income as a percentage of sales was about 6.3% and McDonald's was about
14.6%.

Balance Sheet:

One application of the vertical analysis idea is to state the separate assets of a company as
percentages of total sales. A common type statement of an electronic company is shown
below:

Common Size Comparative Balance Sheet

      December 31, 2002, and 2001
     (dollars in thousands)

      Common-Size Percentages

  2002 2001 2002 2001

Assets        

Current assets:        
Cash $ 1,200 $ 2,350 3.8% 8.1%

Accounts receivable, net 6,000 4,000 19.0% 13.8%

Inventory 8,000 10,000 25.4% 34.5%

Prepaid expenses 300 120 1.0% 0.4%

  ------------ ------------ ----------- ------------

Total current assets 15,500 16,470 49.2% 56.9%

  ------------ ------------ ------------ ------------

Property and equipment:        

Land 4,000 4,000 12.7% 13.8%

Building and equipment 12,000 8,5000 38.1% 29.3%

  ------------ ------------ ------------ ------------

Total property and equipment 16,000 12,500 50.8% 43.1%

  ------------ ------------ ------------ ------------

Total assets $ 31,500 $ 28,970 100.0% 100.0%

  ====== ====== ====== ======

Liabilities and Stockholders' Equity

       

Current liabilities:        
Accounts payable $ 5,800 $ 4,000 18.4% 13.8%

Accrued payable 900 400 2.9% 1.4%

Notes payable, short term 300 600 1.0% 2.1%

  ------------ ------------ ------------ ------------

Total current liabilities 7,000 5,000 22.2% 17.3%

  ------------ ------------ ------------ ------------

Long term liabilities:        

Bonds payable, 8% 7,500 8,000 23.8% 27.6%

  ------------ ------------ ------------ ------------

Total liabilities 14,500 13,000 46.0% 44.9%

  ------------ ------------ ------------ ------------

Stockholders' equity:        
Preferred stock, $100, 6%, $100 liquidation value 2,000 2,000 6.3% 6.9%

Common stock, $12 par 6,000 6,000 19.0% 20.7%

Additional paid in capital 1,000 1,000 3.2% 3.5%

  ------------ ------------ ------------ ------------

Total paid in capital 9,000 9,000 28.6% 31.1%

Retained earnings 8,000 6,970 25.4% 24.1%

  ------------ ------------ ------------ ------------

Total stockholders equity 17,000 15,970 54.0% 55.1%

  ------------ ------------ ------------ ------------

  $ 31,500 $ 28,970 100.0% 100.%

  ====== ====== ====== ======

         

*Each asset in common size statement is expressed in terms of total assets, and each liability and equity account is
expressed in terms of total liabilities and stockholders' equity. For example, the percentage figure above for cash in 2002
is computed as follows: 
[$1,200 /  $31,500 = 3.8%]

Notice from the above example that placing all assets in common size form clearly shows
the relative importance of the current assets as compared to the non-current assets. It also
shows that the significant changes have taken place in the composition of the current assets
over the last year. Notice, for example, that the receivables have increased in relative
importance and that both cash and inventory have declined in relative importance. Judging
from the sharp increase in receivables, the deterioration in cash position may be a result of
inability to collect from customers.

The main advantages of analyzing a balance sheet in this manner is that the balance sheets
of businesses of all sizes can easily be compared. It also makes it easy to see relative
annual changes in one business.

Income Statement:

Another application of the vertical analysis idea is to place all items on the income
statement in percentage form in terms of sales. A common size statement of this type of an
electronics company is shown below:
 

Common-Size Comparative income statement

For the year ended December 31, 2002, and 2001
(dollars in thousands)

      Common-Size Percentage

  2002 2001 2002 2001

Sales $52,000 $48,000 100.0% 100.0%

Cost of goods sold 36,000 31,500 69.2% 65.6%

  ------------ ------------ ------------ ------------

Gross margin 16,000 16,500 30.8% 34.4%

  ------------ ------------ ------------ ------------

Operating expenses:        
Selling expenses 7,000 6,500 13.5% 13.5%

Administrative expense 5,860 6,100 11.3% 12.7%

  ------------ ------------ ------------ ------------

Total operating expenses 12,860 12,600 24.7% 26.2%

  ------------ ------------ ------------ ------------

Net operating income 3,140 3,900 6% 8.1%

Interest expense 640 700 1.2% 1.5%

  ------------ ------------ ------------ ------------

Net income before taxes 2,500 3,200 4.8% 6.7%

Income tax (30%) 750 960 1.4% 2.0%

  ------------ ------------ ------------ ------------

Net income $ 1,750 $2,240 3.4% 4.7%

  ====== ====== ====== ======

 *Note that the percentage figures for each year are expressed in terms of total sales for the year. For example, the
percentage figure for cost of goods sold in 2002 is computed as follows:
[($36,000 / $52,000) × 100  = 69.2%]

By placing all items on the income statement in common size in terms of sales, it is possible
to see at a glance how each dollar of sales is distributed among the various costs, expenses,
and profits. And by placing successive years' statements side by side, it is easy to spot
interesting trends. For example, as shown above, the cost of goods sold as a percentage of
sales increased from 65.6% in 2001 to 69.2% in 2002. Or looking at this form a different
view point , the gross margin percentage declined from 34.4% in 2001 to 30.8% in 2002.
Managers and investment analysis often pay close attention to the gross margin percentage
since it is considered a broad gauge of profitability. The gross margin percentage is
computed by the following formula:

Gross margin percentage = Gross margin / Sales

The gross margin percentage tends to be more stable for retailing companies than for
other service companies and for manufacturers. Since the cost of goods sold in retailing
exclude fixed costs. When fixed costs are included in the cost of goods sold figure, the gross
margin percentage tends to increase of decrease with sales volume. The fixed costs are
spread across more units and the gross margin percentage improves.

While a higher gross margin percentage is considered to be better than a lower gross
margin percentage, there are exceptions. Some companies purposely choose a strategy
emphasizing low prices and (hence low gross margin). An increasing gross margin in such a
company might be a sign that the company's strategy is not being effectively implemented.

Common size statements are also very helpful in pointing out efficiencies and inefficiencies
that might other wise go unnoticed. To illustrate, selling expenses, in the above example of
electronics company , increased by $500,000 over 2001. A glance at the common-size
income statement shows, however, that on a relative basis, selling expenses were no higher
in 2002 than in 2001. In each year they represented 13.5% of sales.

The Structure of the CFS

The cash flow statement is distinct from the income statement and balance sheet because it does not
include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore,
cash is not the same as net income, which, on the income statement and balance sheet, includes cash
sales and sales made on credit. (For background reading, see Analyze Cash Flow The Easy Way.)
Cash flow is determined by looking at three components by which cash enters and leaves a company:
core operations, investing and financing,

Operations
Measuring the cash inflows and outflows caused by core business operations, the operations
component of cash flow reflects how much cash is generated from a company's products or services.
Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable are
reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting
differences in revenue, expenses and credit transactions (appearing on the balance sheet and income
statement) resulting from transactions that occur from one period to the next. These adjustments are
made because non-cash items are calculated into net income (income statement) and total assets and
liabilities (balance sheet). So, because not all transactions involve actual cash items, many items have to
be re-evaluated when calculating cash flow from operations.

For example, depreciation is not really a cash expense; it is an amount that is deducted from the total
value of an asset that has previously been accounted for. That is why it is added back into net sales for
calculating cash flow. The only time income from an asset is accounted for in CFS calculations is when
the asset is sold.

Changes in accounts receivable on the balance sheet from one accounting period to the next must also
be reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the
company from customers paying off their credit accounts - the amount by which AR has decreased is
then added to net sales. If accounts receivable increase from one accounting period to the next, the
amount of the increase must be deducted from net sales because, although the amounts represented in
AR are revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company has spent more money to purchase
more raw materials. If the inventory was paid with cash, the increase in the value of inventory is
deducted from net sales. A decrease in inventory would be added to net sales. If inventory was
purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount
of the increase from one year to the other would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has
been paid off, then the difference in the value owed from one year to the next has to be subtracted
from net income. If there is an amount that is still owed, then any differences will have to be added to
net earnings. (For mroe insight, see Operating Cash Flow: Better Than Net Income?)

Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from
investing are a "cash out" item, because cash is used to buy new equipment, buildings or short-term
assets such as marketable securities. However, when a company divests of an asset, the transaction is
considered "cash in" for calculating cash from investing.

Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from
financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a
company issues a bond to the public, the company receives cash financing; however, when interest is
paid to bondholders, the company is reducing its cash.

Analyzing an Example of a CFS

Let's take a look at this CFS sample:

From this CFS, we can see that the cash flow for FY 2003 was $1,522,000. The bulk of the positive cash
flow stems from cash earned from operations, which is a good sign for investors. It means that core
operations are generating business and that there is enough money to buy new inventory. The
purchasing of new equipment shows that the company has cash to invest in inventory for growth.
Finally, the amount of cash available to the company should ease investors' minds regarding the notes
payable, as cash is plentiful to cover that future loan expense.

Of course, not all cash flow statements look this healthy, or exhibit a positive cash flow. But a negative
cash flow should not automatically raise a red flag without some further analysis. Sometimes, a negative
cash flow is a result of a company's decision to expand its business at a certain point in time, which
would be a good thing for the future. This is why analyzing changes in cash flow from one period to the
next gives the investor a better idea of how the company is performing, and whether or not a company
may be on the brink of bankruptcy or success. (For information on cash flow accounting, see Cash Flow
On Steroids: Why Companies Cheat.)

Tying the CFS with the Balance Sheet and Income Statement
As we have already discussed, the cash flow statement is derived from the income statement and the
balance sheet. Net earnings from the income statement is the figure from which the information on the
CFS is deduced. As for the balance sheet, the net cash flow in the CFS from one year to the next should
equal the increase or decrease of cash between the two consecutive balance sheets that apply to the
period that the cash flow statement covers. (For example, if you are calculating a cash flow for the year
2000, the balance sheets from the years 1999 and 2000 should be used.)

Conclusion
A company can use a cash flow statement to predict future cash flow, which helps with matters in
budgeting. For investors, the cash flow reflects a company's financial health: basically, the more cash
available for business operations, the better. However, this is not a hard and fast rule. Sometimes a
negative cash flow results from a company's growth strategy in the form of expanding its operations.

By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what
some people consider the most important aspect of a company: how much cash it generates and,
particularly, how much of that cash stems from core operations.