RATIOS ANALYSIS

Introduction
A sustainable business and mission requires effective planning and financial management. Ratio analysis
is a useful management tool that will improve your understanding of financial results and trends over time,
and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint
strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio
analysis to measure results against other organizations or make judgments concerning management
effectiveness and mission impact.

Definition
Ratio analysis is an accounting method that uses financial statements, like balance sheets and income
statements, to gain insights into a company's financial health. Ratio analysis will help determine various
aspects of an organization including profitability, liquidity and market value. Financial ratios can be
computed using data found in financial statements such as the balance sheet and income statement. Ratios
are grouping into liquidity ratios, leverage ratios, efficiency ratio, profitability ratios and market value
ratios but our lecture would be centre on the first four mentioned while the last one which is market value
ration would at your three hundred level.

For ratios to be useful and meaningful, they must be:

➢ Calculated using reliable, accurate financial information (does your financial information reflect your
true cost picture?)
➢ Calculated consistently from period to period
➢ Used in comparison to internal benchmarks and goals
➢ Used in comparison to other companies in your industry
➢ Viewed both at a single point in time and as an indication of broad trends and issues over time
➢ Carefully interpreted in the proper context, considering there are many other important factors and
indicators involved in assessing performance.

Ratios can be divided into four major categories:

❖ Profitability Sustainability
❖ Operational Efficiency
❖ Liquidity
❖ Leverage (Funding – Debt, Equity, Grants)

The ratios presented below represent some of the standard ratios used in business practice and are provided
as guidelines. Not all these ratios will provide the information you need to support your particular decisions
and strategies. You can also develop your own ratios and indicators based on what you consider important
and meaningful to your organization and stakeholders.

Profitability Sustainability Ratios

How well is our business performing over a specific period, will your social enterprise have the financial
resources to continue serving its constituents tomorrow as well as today?

1. Sales Growth = Current Period – Previous Period Sales x 100

Previous Period Sales

Percentage increase (decrease) in sales between two time periods. If overall costs and inflation are
increasing, then you should see a corresponding increase in sales. If not, then may need to adjust pricing
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policy to keep up with costs.

2. Reliance on Revenue Source = Revenue Source

Total Revenue

Measures the composition of an organization’s revenue sources (examples are sales, contributions, grants).
The nature and risk of each revenue source should be analyzed. Is it recurring, is your market share growing,
is there a long term relationship or contract, is there a risk that certain grants or contracts will not be
renewed, is there adequate diversity of revenue sources? Organizations can use this indicator to determine
long and short-term trends in line with strategic funding goals (for example, move towards self-sufficiency
and decreasing reliance on external funding).

3. Operating Self-Sufficiency = Business Revenue

Total Expenses

Measures the degree to which the organization’s expenses are covered by its core business and is able to
function independent of grant support. For the purpose of this calculation, business revenue should exclude
any non-operating revenues or contributions. Total expenses should include all expenses (operating and
non-operating) including social costs. A ratio of 1 means you do not depend on grant revenue or other
funding.

4. Gross Profit Margin = Gross Profit

Total Sales

How much profit is earned on your products without considering indirect costs. Is your gross profit margin
improving? Small changes in gross margin can significantly affect profitability. Is there enough gross profit
to cover your indirect costs. Is there a positive gross margin on all products?

5. Net Profit Margin = Net Profit

Sales
How much money are you making per every ₦ of sales. This ratio measures your ability to cover all
operating costs including indirect costs

6. SGA to Sales = Indirect Costs (sales, general, admin)

Sales

Percentage of indirect costs to sales. Look for a steady or decreasing ratio which means you are controlling
overhead.

7. Return on Assets = Net Profit

Average Total Assets

Measures your ability to turn assets into profit. This is a very useful measure of comparison within an
industry. A low ratio compared to industry may mean that your competitors have found a way to operate
more efficiently. After tax interest expense can be added back to numerator since ROA measures
profitability on all assets whether or not they are financed by equity or debt

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Operational Efficiency Ratios
How efficiently are you utilizing your assets and managing your liabilities? These ratios are used to compare
performance over multiple periods.

1. Operating Expense Ratio = Operating Expenses

Total Revenue

Compares expenses to revenue. A decreasing ratio is considered desirable since it generally indicates
increased efficiency.

2. Accounts Receivable Turnover = Credit/Net Sales

Average Accounts Receivable

Number of times trade receivables turnover during the year. The higher the turnover, the shorter the time
between sales and collecting cash.

3. Days in Accounts Receivable = Average Accounts Receivable x 365days

Sales

What are your customer payment habits compared to your payment terms. You may need to step up your
collection practices or tighten your credit policies. These ratios are only useful if majority of sales are credit
(not cash) sales.

4. Inventory Turnover = Cost of Sales

Average Inventory
The number of times you turn inventory over into sales during the year or how many days it takes to sell
inventory.

5. Days in Inventory = Average Inventory x 365days

Cost of Sales

This is a good indication of production and purchasing efficiency. A high ratio indicates inventory is selling
quickly and that little unused inventory is being stored (or could also mean inventory shortage). If the ratio
is low, it suggests overstocking, obsolete inventory or selling issues.

6. Accounts Payable Turnover = Credit /Net Purchase

Average Accounts Payable

The number of times trade payables turn over during the year. The higher the turnover, the shorter the period
between purchases and payment. A high turnover may indicate unfavourable supplier repayment terms. A
low turnover may be a sign of cash flow problems.

7. Days in Accounts Payable = Average Accounts Payable x 365

Credit /Net Purchase

Compare your days in accounts payable to supplier terms of repayment.

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8. Total Asset Turnover = Revenue
Average Total Assets

How efficiently your business generates sales on each naira of assets.

9. Fixed Asset Turnover = Revenue

Average Fixed Assets

An increasing ratio indicates you are using your assets more productively.

Liquidity Ratios
Does your enterprise have enough cash on an ongoing basis to meet its operational obligations? This is an
important indication of financial health.

1. Current Ratio = Current Assets

Current Liabilities
This is also known as Working Capital Ratio. This measures your ability to meet short term obligations
with short term assets., a useful indicator of cash flow in the near future.

A social enterprise needs to ensure that it can pay its salaries, bills and expenses on time. Failure to pay
loans on time may limit your future access to credit and therefore your ability to leverage operations and
growth.

A ratio less that 1 may indicate liquidity issues. A very high current ratio may mean there is excess cash
that should possibly be invested elsewhere in the business or that there is too much inventory. Most believe
that a ratio between 1.2 and 2.0 is sufficient.

The one problem with the current ratio is that it does not take into account the timing of cash flows. For
example, you may have to pay most of your short term obligations in the next week though inventory on
hand will not be sold for another three weeks or account receivable collections are slow.

2. Quick Ratio = (Current Assets – Inventory) /Cash +AR + Marketable Securities

Current Liabilities

A more stringent liquidity test that indicates if a firm has enough short-term assets (without selling
inventory) to cover its immediate liabilities. This is often referred to as the “acid test” because it only looks
at the company’s most liquid assets only (excludes inventory) that can be quickly converted to cash). A
ratio of 1:1 means that a social enterprise can pay its bills without having to sell inventory.

3. Working Capital = Current Assets – Current Liabilities

WC is a measure of cash flow and should always be a positive number. It measures the amount of capital
invested in resources that are subject to quick turnover. Lenders often use this number to evaluate your
ability to weather hard times. Many lenders will require that a certain level of WC be maintained.

4. Adequacy of Resources = Cash + Marketable Securities + Accounts Receivable

Monthly Expenses
Determines the number of months you could operate without further funds received (burn rate)
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Leverage Ratios
To what degree does an enterprise utilize borrowed money and what is its level of risk? Lenders often use
this information to determine a business’s ability to repay debt.

1. Debt to Equity = Short Term Debt + Long Term Debt

Total Equity (including grants)

Compares capital invested by owners/funders (including grants) and funds provided by lenders. Lenders
have priority over equity investors on an enterprise’s assets. Lenders want to see that there is some cushion
to draw upon in case of financial difificulty. The more equity there is, the more likely a lender will be
repaid. Most lenders impose limits on the debt/equity ratio, commonly 2:1 for small business loans.

Too much debt can put your business at risk, but too little debt may limit your potential. Owners want to
get some leverage on their investment to boost profits. This has to be balanced with the ability to service
debt.

2. Interest Coverage = EBITDA

Interest Expense

Measures your ability to meet interest payment obligations with business income. Ratios close to 1 indicates
company having difficulty generating enough cash flow to pay interest on its debt. Ideally, a ratio should
be over 1.5

Other Ratios
You may want to develop your own customized ratios to communicate results that are specific and
important to your organization. Here are some examples.

1. Operating Self-Sufficiency = Sales Revenue

Total Costs (Operating and Social Costs)

2. % Staffing Costs spent on Target Group = Target Staff Costs

Total Staffing Costs

3. Social Costs per Employee = Total Social Costs

Number of Target Employees

4. % Social Costs covered by Grants = Grant Income

Total Social Costs