Financial Ratios

Financial Ratios
 Leverage Ratios which show the extent that debt is used in a company's capital
structure.
 Liquidity Ratios which give a picture of a company's short term financial
situation or solvency.
 Operational Ratios which use turnover measures to show how efficient a
company is in its operations and use of assets.
 Profitability Ratios which use margin analysis and show the return on sales and
capital employed.
 Solvency Ratios which give a picture of a company's ability to generate cashflow
and pay it financial obligations.
Balance Sheet Ratio Analysis
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:
Current Ratio = Total Current Assets / 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 feel 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:
Quick Ratio = Cash + Government Securities + Receivables / 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):
Debt/Worth Ratio = Total Liabilities / 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 Margin Ratio = Gross Profit / Net Sales
Reminder: 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 Margin Ratio = Net Profit Before Tax / 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:
Inventory Turnover Ratio = Net Sales / 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. Getting the Accounts Receivable Turnover Ratio is a two
step process and is is calculated as follows:
Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)
Accounts Receivable Turnover (in days) = Accounts Receivable / 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:
Return on Assets = Net Profit Before Tax / 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:
Return on Investment = Net Profit before Tax / 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.

Financial Ratios

Uploaded by

Copyright:

Available Formats

Financial Ratios

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Ratios

Uploaded by

Copyright:

Available Formats

Financial Ratios

Balance Sheet Ratio Analysis

Current Ratio = Total Current Assets / Total Current Liabilities

 Paying some debts.

Quick Ratio = Cash + Government Securities + Receivables / Total Current Liabilities

Working Capital = Total Current Assets - Total Current Liabilities

Debt/Worth Ratio = Total Liabilities / Net Worth

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

Reminder: Gross Profit = Net Sales - Cost of Goods Sold

Net Profit Margin Ratio

Inventory Turnover Ratio

Inventory Turnover Ratio = Net Sales / Average Inventory at Cost

Accounts Receivable Turnover Ratio

Return on Assets Ratio

Return on Assets = Net Profit Before Tax / Total Assets

Return on Investment (ROI) Ratio

Return on Investment = Net Profit before Tax / Net Worth

You might also like