Financial ratios

Financial ratios are a valuable and easy way to interpret the numbers found in statements. Ratios 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 company assets are being used properly to generate income.

A good indication of the company’s financial strengths and weaknesses becomes clear when computing financial relationships. Examining these ratios over time provides insight into 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 and 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.

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. 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.

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 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 and evaluates its 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. Also called return on investment (ROI), this determines the rate of return on 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 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 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 capacity to take on additional debt without impairing its survival.

The formula is:

Net profit + any non-cash expenses
__________________________

Principal on debt

 

Authored by: SBDC Counseling Committee, SBDC Finance Committee, SBDC Marketing Committee and The Florida SBDC
Source: MO SBTDC Professional Development Manual.
Reviewed/updated by Rayanna Anderson, director, MO SBTDC at MSU