Financial Ratio Analysis

Financial Ratio Analysis

• Financial ratio analysis is a way of appraising their

• Liquidity ratios demonstrate a company's ability

Formula:
Current Ratio = Current Assets ÷ Current Liabilities
-measures the ability of an entity to pay its near-term
obligations. "Current" usually is defined as within one
year
Rule of Thumb:
it should be at least 2:1
Formula:
Quick Ratio = (Cash + AR) ÷ Current Liabilities
- provides a stricter definition of the company's ability to
make payments on current obligations
Rule of Thumb
Ideally, this ratio should be 1:1. If it is higher

Formula:
Cash to total assets: Cash ÷ Total Assets
- measures the portion of a company's assets held in cash
or marketable securities.
Rule of Thumb
High ratio may indicate some degree of safety from a
creditor's viewpoint, excess amounts of cash may be
viewed as inefficient
Formula:
Sales to receivables (or turnover ratio): Net Sales ÷ Accounts Receivable
- measures the annual turnover of accounts receivable.
Rule of Thumb
High number reflects a short lapse of time between sales and the
collection of cash, while a low number means collections take longer

Formula:
Days' receivables ratio: 365 ÷ Sales to receivables ratio
- measures the average number of days that accounts
receivable are outstanding
Rule of Thumb
Number should be the same or lower than the company's
expressed credit terms
Formula:
Cost of sales to payables: Cost of Sales ÷ Trade Payables
—measures the annual turnover of accounts payable
Rule of Thumb
Lower numbers tend to indicate good performance, though
the ratio should be close to the industry standard

Formula:
Cash turnover: Net Sales ÷ Net Working Capital (current
assets less current liabilities)
—reflects the company's ability to finance current operations, the
efficiency of its working capital employment, and the margin of
protection for its creditors.
Rule of Thumb
High cash turnover ratio may leave the company vulnerable to
creditors, while a low ratio may indicate an inefficient use of
working capital
Solvency Ratios
• Solvency ratios look at the extent to which a
company has depended upon borrowing to
finance its operations. As a result, these ratios
are reviewed closely by bankers and investors.
Most leverage ratios compare assets or net
worth with liabilities. A high leverage ratio may
increase a company's exposure to risk and
business downturns, but along with this higher
risk also comes the potential for higher
returns.
Formula:
Debt to equity ratio: Debt ÷ Owners' Equity
—indicates the relative mix of the company's investor-
supplied
Rule of Thumb
Debt should be between 50 and 80 percent of equity.

Formula:
Debt ratio: Debt/Total Assets
—measures the portion of a company's capital that is
provided by borrowing.
Rule of Thumb
A debt ratio greater than 1.0 means the company has
negative net worth, and is technically bankrupt. This ratio
is similar, and can easily be converted to, the debt to
equity ratio
PROFITABILITY OR RETURN ON
INVESTMENT RATIOS
• Profitability ratios provide information about
management's performance in using the resources
of the small business. Many entrepreneurs decide to
start their own businesses in order to earn a better
return on their money than would be available
through a bank or other low-risk investments. If
profitability ratios demonstrate that this is not
occurring—particularly once a small business has
moved beyond the start-up phase—then
entrepreneurs for whom a return on their money is
the foremost concern may wish to sell the business
and reinvest their money elsewhere
Formula:
Gross profitability: Gross Profits ÷Net Sales
—measures the margin on sales the company is achieving.
Rule of Thumb
It can be an indication of manufacturing efficiency, or
marketing effectiveness.

Formula:
Net profitability: Net Income ÷Net Sales
—measures the overall profitability of the company, or how
much is being brought to the bottom line..
Rule of Thumb
net profitability shows the effectiveness of management.
Though the optimal level depends on the type of business,
the
ratios can be compared for firms in the same industry.
Formula:
Return on assets: Net Income ÷Total Assets
—indicates how effectively the company is deploying its
assets..
Rule of Thumb
This ratio can be distorted by depreciation or any unusual
expenses.

Formula:
Return on investment 1: Net Income ÷Owners' Equity
— ROI is considered to be one of the best indicators of
profitability
Rule of Thumb
If this ratio is too low, it can indicate poor management
performance or a highly conservative business approach. On
the other hand, a high ROI can mean that management is
doing a good job, or that the firm is undercapitalized
Formula:
Return on investment 2: Dividends +/- Stock Price
Change/Stock Price Paid
—ROI measures the gain (or loss) achieved by placing an
investment over a period of time.
Rule of Thumb
ROI measures the gain (or loss)

Formula:
Earnings per share: Net Income/Number of Shares
Outstanding
— states a corporation's profits on a per-share basis
Rule of Thumb
can be helpful in further comparison to the market price
of the stock.
Formula:
Return on investment 2: Dividends +/- Stock Price
Change/Stock Price Paid
—ROI measures the gain (or loss) achieved by placing an
investment over a period of time.
Rule of Thumb
ROI measures the gain (or loss)

Formula:
Investment turnover: Net Sales/Total Assets
— measures a company's ability to use assets to generate sales
Rule of Thumb
the ideal level for this ratio varies greatly, a very low figure may
mean that the company maintains too many assets or has not
deployed its assets well, whereas a high figure means that the
assets have been used to produce good sales numbers
Formula:
Sales per employee: Total Sales/Number of Employees
—Can provide a measure of productivity.
Rule of Thumb
A high figure relative to one's industry average can
indicate either good personnel management or good
equipment.
EFFICIENCY RATIOS
• By assessing a company's use of credit,
inventory, and assets, efficiency ratios can help
small business owners and managers conduct
business better. These ratios can show how
quickly the company is collecting money for its
credit sales or how many times inventory turns
over in a given time period
Formula:
Annual inventory turnover: Cost of Goods Sold for the
Year/Average Inventory
—shows how efficiently the company is managing its
production, warehousing, and distribution of product,
considering its volume of sales
Rule of Thumb
Higher ratios—over six or seven times per year—are generally
thought to be better

Formula:
Inventory holding period: 365 ÷ Annual Inventory Turnover
Rule of Thumb
Calculates the number of days, on average, that elapse
between finished goods production and sale of product.
Formula:
Inventory to assets ratio Inventory/Total Assets
—shows the portion of assets tied up in inventory.
Rule of Thumb
Lower ratio is considered better

Formula:
Accounts receivable turnover Net (credit) Sales/Average Accounts
Receivable
— gives a measure of how quickly credit sales are turned into cash
Rule of Thumb
The reciprocal of this ratio indicates the portion of a year's credit
sales that are outstanding at a particular point in time.
Formula:
Collection period 365 ÷ Accounts Receivable Turnover
Rule of Thumb
Measures the average number of days the company's
receivables are outstanding, between the date of credit sale
and collection of cash
Thank you 