Guide to Financial Ratios Analysis

What is 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

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 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:

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

(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. The Accounts Receivable Turnover Ratio is calculated as follows:

Net Credit Sales/Year
__________________ = Daily Credit Sales
365 Days/Year

Accounts Receivable Turnover (in days) =

Accounts Receivable
_________________________
Daily Credit Sales

Evaluate your budget periodically with actual operations statistics. With powerful records you can do this. Then, where
discrepancies appear you can take corrective actions before it's too late. The right choices for the ideal corrective action
depends upon your knowledge of management techniques in purchasing, pricing, selling, selecting and training personnel, and
handling other management issues.

You're thinking you can hire a bookkeeper or a Accountant to handle the record keeping for you. Yes, you can. But remember two
very important facts:

1. Supply the accountant with true input. Should you buy something And don't record the amount in your business checkbook, the
accountant can't enter it. If you sell something for money and do not record it, then the accountant won't know about it. The
documents the accountant prepares will probably be no greater than the info that you provide.

2. Utilize the documents to make conclusions. If you went to a doctor And he told you you were ill and wanted certain medication
to get well, you'd follow his guidance. If you pay an accountant and he informs you that your earnings are down this year, don't
hide your head in the sand and pretend the issue will go off. It won't.

Business Management Roll in Personnel Selection. If your business Will be big enough to require outside help, an important duty
will be the selection and training of one or more workers. You may begin with family members or business partners that will assist
you. But when the business develops - as you expect it will - the time will come when you have to select and train employees.

Careful selection of employees is vital. To Pick the right Employees decide beforehand what you need each one to perform.

Then look for applicants to fill these particular needs. In a small Business you may need flexible employees who can shift from
task to task as needed. Include this in the outline of all those jobs you would like to fill. At the exact same time, look ahead
and plan your hiring to assure an organization of people capable of accomplishing every crucial role. In a retail store, a
salesperson may likewise do stock-keeping or accounting at the outset, but as the business grows you'll need sales people,
stock-keepers and bookkeepers.

Once the job descriptions are composed, line up applicants whom To make a choice. Do not be swayed by clients who may suggest
relatives. If the candidate doesn't succeed, you might drop a client as well as an employee. Some sources of potential new
employees are:

1. Recommendations with friends, business acquaintances. 2. Employment agencies. 3. Placement agencies of high schools, business
schools, and colleges. 4. Trade and industrial associations. 5. Help-wanted advertisements in neighborhood newspapers.

Your next task is to screen want ad responses and/or application Forms delivered by employment agencies. Some applicants will be
removed sight unseen. For each of the other people, the application form or letter will act as a foundation for the interview that
ought to be conducted in private. Put the applicant at ease by describing your company in general and the job particularly. As
soon as you have done this, encourage the applicant to speak. Picking the right individual is very important. Ask your questions
carefully to learn everything about the applicant that's pertinent to this job.

References are a must, and should be checked before making a final decision. Check through an individual visit or a phone call
directly to the applicant's immediate previous manager, if possible. Verify that the information given you is correct. Consider,
with conclusion, any negative comments you hear and what isn't said.

Checking references can bring to light significant Details Which may save you money and potential annoyance.

Personnel Training. A well-selected employee is only a potential Asset to your organization. Whether he or she becomes a true
asset depends upon your own training. Recall:

To allow adequate time for training. Not to anticipate too much from The trainee in too brief a time. To allow the employee learn
by performing under actual working conditions, with close supervision. To follow up on your training.

Examine the employee's operation after he or she was in work For a moment. Re-explain key points and short cuts; bring the
employee up to date on new developments and encourage questions. Training is an ongoing process which becomes excruciating
supervision.

Personnel Supervision. Supervision is the next essential of personnel control. Good oversight will reduce the expense of operating
your company by cutting down on the amount of worker errors. If mistakes are corrected early, workers will get more satisfaction
out of their jobs and perform much better.

Motivating Employees. Small businesses sometimes face particular Problems in motivating employees. In a large company, a good
employee can see An chance to progress into management. In a small business, you are the management. One thing you Might Wish to
consider is to provide good workers a Small share of their proceeds, either via part-ownership or a profit-sharing plan. Somebody
Who has a"share of the activity" is going to be more Concerned about helping to make a success of the business enterprise.

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