Financial Ratio Analysis

The Balance Sheet of a company and Statement of Income are important, but these are only the starting point for effective and successful financial management. Applying Financial Ratio Analysis to Financial Statements helps to analyze the failure, success, and progress of a business.

Ratio Analysis enables a business owner or the manager to spot trends in business and to compare the performance and condition of the business with the average performance of similar businesses in similar industries.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure the liquidity and solvency (ability of a business to pay its bills as they become due) and leverage (extent to which the business is dependent on the creditors' funding). These include the following ratios:

Liquidity Ratios

Liquidity ratios indicate the ease of converting assets into cash. Current Ratio, Quick Ratio, and Working Capital are included in Liquidity ratios

Current Ratios:

This is one of the best known measures of financial strength. It is calculated as shown below:

Current Ratio = Total Current Assets/Total Current Liabilities

The main concern of this ratio is to know whether a business has enough current assets to meet current liabilities with a margin of safety for possible losses in current assets, like inventory shrinkage or collectable accounts. In general, the acceptable current ratio is 2 to 1. However, to know whether or not a particular ratio is satisfactory depends on the nature of business as well as on the characteristics of the current assets and liabilities. The minimum acceptable current ratio is 1:1.

Quick Ratios:

The Quick Ratio is also called the "acid-test" ratio and is one of the best measures of liquidity. It is calculated as shown below:

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

The Quick Ratio is a much more accurate measure as compared to the Current Ratio. It excludes inventories and concentrates on the really liquid assets, with a value that is fairly certain. It helps in knowing that incase all sales revenues disappear, could a business meet its current obligations with readily convertible `quick' funds on hand.

An acid-test of 1:1 is considered as satisfactory unless majority of quick assets are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying the current liabilities.

Working Capital:

It's more a measure of cash flow than a ratio. The result of this working capital calculation must be a positive number. It is arrived at as shown below:

Working Capital = Total amount of Current Assets - Total Current Liabilities

Bankers consider Net Working Capital over time to determine a company's ability to weather financial crisis. Loans are often dependant on the minimum working capital requirements.

Leverage Ratio

The Leverage Ratio or Debt/Worth ratio indicates the extent to which a business is reliant on debt financing (that is creditor money versus the owner's equity):

Debt/Worth Ratio or Liquidity ratio = Total Liabilities/Net Worth

In general, the higher this ratio, the more risky a creditor will perceive its exposure in the business, making it harder to obtain credit.

Income Statement Ratio Analysis

The following important Statement of Income Ratios measure the profitability of a business:

Gross Margin Ratio

This ratio is the percentage of sales left after subtracting the cost of the goods sold from net sales. It measures the percentage of sales remaining (after obtaining or manufacturing the goods sold) available in order to pay the overhead expenses of a company.

Comparison of business ratios to those of similar businesses reveals the relative strengths or weaknesses of business. The Gross Margin Ratio is computed as follows:

Gross Margin Ratio = Gross Profit/Net Sales

(Gross Profit = Net Sales - Cost of Goods Sold)

Net Profit Margin Ratio

This ratio is a percentage of sales left after subtracting Cost of Goods sold and all expenses, except the income taxes. It helps in comparing a company's "return on sales" with the performance of other companies in same industry. It is calculated before the income tax since tax rates and tax liabilities differ from company to company for a wide variety of reasons, making the comparisons after taxes extremely difficult. The Net Profit Margin Ratio is computed as follows:

Net Profit Margin Ratio = Net Profit before Tax/Net Sales

Management Ratios

Other important ratios, also referred to as Management Ratios, also are derived from information based on the Balance Sheet and Statement of Income.

Inventory Turnover Ratio

This ratio reveals how well the inventory is being managed. It is important since more times the inventory can be turned in a specified operating cycle, the greater will be the profit. The Inventory Turnover Ratio is calculated as given below:

Inventory Turnover Ratio = Net Sales/Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio gives detail as to how well accounts receivable are being collected. The Accounts Receivable Turnover Ratio is calculated as follows:

(Net Credit Sales/Year)
__________________       = Daily Credit Sales

(365 Days/Year)

Accounts Receivable Turnover (as in days) = Accounts Receivable/Daily Credit Sales

Return on Assets Ratio

This measures how effectively the profits are being generated from the assets employed in the business when compared with the ratios of firms in similar businesses. Low ratio indicates an inefficient use of 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 one of the most important ratios. It is the percentage of returns on funds invested in a business by the owners. This ratio helps the owner in knowing whether or not the effort put into the business has been worthwhile. The ROI is calculated as follows:

Return on Investment = Net Profit before Tax/Net Worth