ABOUT FINANCIAL RATIO ANALYSIS
Over the years, a great many financial analysis techniques have developed. They
illustrate the relationship between values drawn from the balance sheet and income
statement as ratios and are usually more informative than using dollar amounts. Ratio
analysis is a very useful tool for analyzing the performance and condition of a business.
It is often used to provide information that goes into a business plan; and is used to
make a brief analysis of the financial condition of the business. Financial ratio analysis
enables the small business owner to gauge the businesses financial weaknesses and
strengths and take the appropriate action. It also allows you to compare the
performance of your company with that of similar businesses in your industry. Financial
ratio analysis will generally measure two areas within a company: liquidity (the amount
of liquid assets your business has at any given time to meet accounts or notes payable)
and profitability (the ability of the business to generate revenues, net income and an
acceptable return on investment). Ratios can be expressed in a number of forms. For
example, if sales are $50,000, and net income for the same period is $5,000; the ratio
may be expressed in the following ways: the ratio of sales to net income is 10 to one
(10:1); for $1 of sales the business has a net income of $.10; net income is 1/10 of
sales; net income is 10% of sales; and net income is .10 of sales. Operating ratios
calculated on a continuous basis will serve to identify trends "red flags" regarding
problem areas. Try to obtain industry data to make comparisons and derive your
successes compared to the industry average. Measuring profitability can be computed
either before or after taxes, depending on the purpose of the computations.
Do not assume, however, that ratios and ratio analysis will tell you everything you need
to know about the financial performance of your business; they won’t. Ratios provide a
great deal of illumination, but they do have their limitations; those limitations are: Since
the information used to derive ratios is itself based on accounting rules and personal
judgment as well as facts, the ratios cannot be considered absolute indicators of a firm's
financial position. Also, not all businesses are the same; when comparing ratios with
industry averages, keep in mind that many business people prepare their financial
statements differently from others resulting in financial ratios that may not present an
accurate accounting of the average business in your industry. Finally, ratios are
developed for specific periods; therefore, if you operate a seasonal business, ratios may
not provide an accurate measure of financial performance. Ratios are based on a
company’s past performance; they don’t necessarily offer any indication of present or
future performance. Even though financial ratio analysis has their limitations, they will
be of great help to you in managing your financial situation. Just keep in mind that
ratios are only a means of assessing the performance of the firm and must be
considered in perspective with many other measures. They should be used as a point
of departure for further analysis and not as an end in themselves. A number of
organizations publish financial ratios for various businesses, among them Robert Morris
Associates, Dun and Bradstreet, and Statistics Canada. Your own trade association
may also publish such studies. Remember, these published ratios are only averages.
You probably want to be better than average.
There are nine key business ratios that can be calculated using data from the projected
business balance sheet and income statement. They are used to calculate the
profitability of a business; to make comparison from period to period; comparisons with
other businesses and industries; and measure solvency. Described on the following
pages, you are shown how they are calculated and given. However, having calculated
these ratios you may well be asking: What do I do now? What do the ratios mean?
What do you compare them to? How do you interpret a change in ratios from one year to
the next? In some provinces and states, statistical organizations gather and publish data
on these key ratios for companies so that year-to-year comparisons can be made and
trends plotted. Keep in mind that these are projected ratios. Ratio calculation and
analysis to be used properly is based on past or historical data to help identify present
strengths and weaknesses of a company. After your first year of operation, you will have
sufficient data to calculate the ratios and compare them to the projected ratios calculated
below. This comparison will allow you to make a professional assessment as to the
operations of your business.
MEASURES OF LIQUIDITY / WORKING CAPITAL
The various measures of liquidity / working capital will tell you how much cash on hand
you have, the amount of assets that you can readily turn into cash, and generally how
quickly you can do so. Liquidity is very important because it reflects the ability of a
business to pay its indebtedness. A good rule of thumb for determining your financial
health is the more liquid you are, the better. Perhaps the best known ratio analysis is the
current ratio, quick ratio and inventory turnover ratio. They are described as follows:
Current ratio
The current ratio is simply the ratio of your current assets to your current liabilities or
(current assets divided by current debts) and is a measure of the cash or near cash
position (liquidity) of the firm. You can find your current assets and current liabilities on
your balance sheet. It tells you if you have enough cash (current assets) to pay your
firm's current creditors (current liabilities). It is a measure of short- term solvency. It is
also called the working capital ratio. The higher the ratio, the more liquid the firm's
position is, and hence the higher the creditability of the firm. Current assets normally
include cash, marketable securities, accounts receivable and inventories. Naturally, you
need to be realistic in valuing receivables and inventory for a true picture of your
liquidity, since some debts may be non-collectible and some stock obsolete. Current
liabilities consist of accounts payable, short term notes payable, and accrued expenses.
Current liabilities are those, which must be paid in one year.
The formula for calculation is: " Current Assets / Current Liabilities ". By rule of thumb the
current ratio should be 2 to 1 (2:1 or 200% or 2$ to $1). Normally 150% is satisfactory
and under 100% is not satisfactory. The higher it is, the better the indication, but the
actual quality and management of assets must be considered. A general rule of thumb is
that a current ratio of 2-1 could be considered satisfactory for a typical manufacturing
business. Service firms typically have a lower ratio since they tend to have fewer
inventories. If your current ratio trend is up, it is favorable. If the trend is down, it is
unfavorable. Too high a ratio can indicate the business is not utilizing its cash and other
liquid assets very efficiently; while too low a ratio may raise questions about the firms’
ability to meet its short-term obligations. In actual practice, however, what is more
important than the absolute level of the current ratio is how the ratio is changing over
time. An improving current ratio would tend to indicate improved short-term financial
solvency unless the business is building up excessive or obsolete inventories.
You can compare your current ratio with those of similar companies within your industry
by referring to surveys conducted by various trade associations and marketing
companies. If you feel your current ratio is too low after you evaluate it and compare it to
the industry average, you may be able to increase it in a number of ways. You can
increase your current ratio by paying off some of your debts that appear as current
liabilities, or by turning some of the fixed assets or miscellaneous assets into current
assets. As a last resort you may have to funnel profits back into the business.
Quick ratio
Like the current ratio, the quick ratio or referred to as the (acid-test ratio) also measures
the liquidity of your business. This ratio is a refinement of the current ratio and is a
more conservative measure of liquidity. The quick ratio is found by dividing all your
liquid assets called quick assets by current liabilities. Quick assets are current assets
minus inventory. Quick assets are highly liquid - those which are immediately convertible
to cash (they are cash on hand and any government securities). The purpose, again, is
to test the firm's ability to meet its current obligations. The quick ratio indicates the extent
to which a company could pay current debt without relying on future sales. This test
doesn't include inventory to make it a stiffer test of the company's liquidity. It tells you if
the business could meet its current obligations with quickly convertible assets should
sales revenues suddenly cease. The quick ratio can be used to estimate the ability of
the firm to pay off its short-term obligations without having to sell its inventory. Inventories
tend to lose their value faster than other assets if disposed in a hurry. The quick ratio is
probably a more valid test of the firms’ ability to meet its current liabilities and pay its bills
than the current ratio.
The formula for calculation is: " (Current Assets - Inventory) / Current Liabilities ". By rule of thumb,
the ratio should be 1 to 1 (1:1 or 100% or 1$ to 1$). If below 80-90% you probably have
liquidity problems. If well above 100% you may have an unfavorable balance between
strong and weak earning current assets and further analysis may show that there are
excessive accounts receivable which may require a reevaluation of the credit and
collection policy of the business, it could also reflect an ineffective use of cash. If the
quick ratio trend is up and not much above 100% it is favorable. If the ratio trend is down
it is unfavorable, because the company may be undercapitalized and more investment
may be necessary or business debt should be restructured to reduce the amount of
monthly debt servicing.
The quick ratio is a measure of exactly where you would be if you faced a crisis and had
no way to correct your financial position. Try to keep your quick ratio at a level sufficient
for your needs. Remember, good financial management allows the best use of your
assets and increases the profitability of your business. If you have cash and inventories
that exceed your needs and are lying idle, you are not using them to your greatest
advantage. You have to walk a tight rope between much liquidity and not enough
liquidity.
MEASURES OF PRODUCTIVITY & DEBT
Productivity and debt ratios are an indication of small business management efficiency
and effectiveness. They provide the basis for examining various aspects of the business
by combining both balance sheet and income statement information.
Debt to equity ratio
The debt to equity ratio compares the amount invested in the business by creditors with
that invested by the owner(s). The ratio indicates the firms’ obligations to its creditors
relative to the owners’ level of investment in the business. This ratio is an indication of
leverage, reflecting your financial stability. This ratio is a measure of how the company
can meet its total obligations from equity. The higher the ratio, the greater the risk being
assumed by creditors. The lower the ratio, the higher the proportion of equity relative to
debt and the better the firm's credit rating will be. This ratio is found by: (adding current
debt and long term debt and diving by total equity). Debt includes current liabilities, long
term loans, bonds and deferred payments. The owners’ equity includes the value of
common stock, or cash and assets contributed.
The formula for calculation is: " (Current Debt + Long Term Debt) / Total Equity ". This ratio
indicates financial stability and the lower the better. A ratio greater than one means the
firm is using more debt than equity to finance investments. The higher the ratio, the more
the creditors claim and possibly indicating that the business is extending its debt beyond
its ability to repay. If the debt to equity ratio trend is up, it is unfavorable. If the ratio trend
is down it is favorable and the firm will have greater flexibility to borrow in the future.
However, an extremely low ratio may indicate that the owner is too conservative and is
not letting the business realize its potential.
Accounts receivable collection period
This ratio is helpful in analyzing the collection ability of the receivables, and the efficiency
of your credit and collection system. This ratio tells you the length of time it takes the
firm to get its cash after making a sale on credit. It should be looked at in relation to the
allowable credit period you have established. For example if you have extended credit for
a period of 30 days, your ratio should be very close to that same number of days. As a
rough rule of thumb, the collection period should not exceed 10-15 days longer than the
maturity period of your credit deadline. For example if your terms were net 30 days, the
ratio should not exceed 40-45 days. This extra time allows for mail delays and
processing time. The shorter this period the quicker the cash inflow is. A longer than
normal period may mean overdue and uncollectable bills. This ratio also provides some
indication of the quality of the receivables, and also an idea of how successful the firm is
collecting its outstanding receivables. Generally, the greater number of days outstanding,
the greater the probability of delinquencies in accounts receivable resulting in bad debt. If
your ratio is much longer than the established period, you may need to alter your credit
policies. It's wise to develop an ageing schedule to gauge the trend of collections and
identify slow payers. Slow collections (without adequate financing charges) hurt your
profit, since you could be doing something much more useful with your money, such as
taking advantage of discounts on your own payables.
The formula for calculation is: " Accounts Receivable / (Total Sales / 365 Days) ". If the average
collection period ratio trend is up, it is unfavorable; and means you are financing your
customers and acting as their bank, and the older the accounts receivable, the harder it is
to collect. This can have very negative effects on the management of your business and
the profit potential. You could be paying high debt servicing rates at the bank for the
money that you are in effect lending to your customers. It could also limit the volume
discount purchases that you can make from suppliers to increase your profit line, because
you are stretched in your line of credit at the bank. If the ratio trend is down it is favorable
and it is a sign that you are becoming more efficient in your credit and collection policies.
If it is less than the published collection period for the industry, it usually means your
collection policy is particularly effective. If your ratio is substantially below the industry
average, it may mean that you are loosing sales and you may have a credit policy that is
too stringent.
Inventory turnover
The purpose of this ratio is to show the number of times inventory is sold and replaced
over a given period. This will provide you with a measure of the amount of capital you
invest in inventory to meet your operational requirements; how quickly inventory is sold;
and the efficiency of funds invested in materials and inventory; how often inventory is
liquidated and the quality of the inventory. This ratio is important in showing how
efficiently the inventory is being managed by determining the investment to be made in
inventory, and maintaining a watch on dated stock. The aim here is to maintain and
increase sales while inventory is reduced or at least maintained.
The formula for calculation is: " Total Cost of Goods Sold / Average Inventory on Hand ". A high
turnover rate indicates efficient management, and the ability to turn inventory to cash
quickly and superior merchandising. Conversely it can also indicate a shortage of
needed inventory for sales and poor assortments. If the trend is down, it is unfavorable.
This can indicate poor liquidity, possible overstocking, obsolescence, or in contrast to
these negative interpretations a planned inventory buildup in the case of material
shortages. If inventory turnover is low, it could signal a number of factors: sales volume
has declined; some of the inventory is damaged or dated and therefore difficult to sell; or
if temporary, the firm has stocked up in anticipation of increased sales for Christmas. A
high or increasing rate of inventory turnover generally means that inventory is well
managed. A turnover rate that is too high may mean that inventory is being kept to low,
which could cause a crucial shortage of stock if there is an insufficient number of major
items in inventory. In addition, insufficient stocking may not permit you to present and
extensive enough or interesting enough assortment of products for your customers. If
your ratio deviates considerably from industry standards, it may indicate poor marketing
as well as poor management. If you are selling perishable goods, it is of course
necessary that your inventory turnover rate is very high or you will be suffering a high
spoilage rate and consequent loss in profits.
Operating expense ratio
This ratio will assist you in telling how well you are controlling expenses. It will assist you
to evaluate internal economic efficiency. For example, if you compare this ratio with a
budgeted expense figure developed at the beginning of your year. You can see if your
expenses compare with your projections. If so, there should be little discrepancy between
the two figures. It also indicates the trend of your expenses. Operating expense can be
calculated by the total operating expense amount or by separately dividing each
operating expense such as salaries, or wages, by total sales. From the resulting picture,
owners evaluate internal economic efficiency, and gain valuable management
information.
The formula for calculation is: “ Total Expenses / Total Sales ". This ratio should be compared
to your budget. It should be on budget. If lower than industry norms this is considered
favorable. If the operating expense ratio is up, it is unfavorable; profits are being eroded
because expenses are too high. If the ratio trend is down this is favorable, costs are
being controlled.
PROFITABILITY MEASURES
Throughout your businesses’ lifetime, you will rely on your business for several things.
Making money of course is the highest priority. After all, it is the reason you went into
business in the first place. If your business is not profitable, why put yourself through the
headaches and long hours that usually come with owing your own business. You could
work for someone else secure in the knowledge you will receive a weekly paycheck,
benefits and more free time. Making money is what being in business is all about. This
section discusses several methods that measure just how profitable your business is.
Profitability measures are: gross profit margin, net profit margin, return on investment,
breakeven analysis. Using these profitability measures you will learn how much money
you are making, whether you are using your present resources to maximize the profit
potential of your business, and whether you are losing money or just breaking even.
Gross profit margin
The purpose of this ratio is to determine the percentage of gross profit on each sales
dollar. It reveals the actual percentage of sales revenue available to cover operating and
general expenses, wages and taxes, and provide a profit. If you compare your gross
profit with your average desired markup, you can see the effect of discounts and theft or
spoilage on your business operation. If your ratio is different than your budgeted ratios,
you will want to examine the reasons for this very carefully. The gross margin ratio is the
amount of sales dollars available after subtracting direct costs such as labor and
materials (inventory) to cover both fixed and variable operating expenditures on a daily,
monthly or annual basis.
The formula for calculation is: " Total Gross Margin / Total Sales ". A higher than average
number is desired. If the gross margin ratio trend is up, it is favorable. If the trend is
down it is unfavorable; it may mean that your markup is too low or you are paying too
much for your merchandise. The solution among others is to increase sales, decrease
costs and increase your markup.
Net profit margin
This ratio allows you to determine the percentage of net profit on each sales dollar. Net
profit on sales is one of the most common ratios used to determine the profitability of a
business. It measures the difference between your net sales and what you spend to
operate your business. The net profit ratio measures managements’ ability to control
expenses, pay taxes, and result in a reasonable profit margin on sales. Operating
expenses kept under control through efficient management will result in a constant ratio
over several years.
The formula for calculation is: " Net Profit Before Tax / Total Sales ". If the owners’ salary is a
fair management fee, the ratio will show the average percentage of net profit in each
sales dollar. The higher this ratio is, generally the better. If the net profit ratio trend is up,
it is favorable. If the ratio trend is down it is unfavorable, and you should look at your
mark up policy and expenses. Most experts agree that if your ratio of net profit to sales
does not exceed the amount of money that you could earn from interest or dividends in
securities then you are not utilizing your assets to your best advantage. Check the
average ratios of similar businesses with your industry and compare your net profit on
sales against theirs. If your net profit on sales is substantially lower, you should reevaluate the areas in your business that could reduce your earning power. Those areas
might be high operating costs, high shrinkage, or a price point that may not produce
sufficient profit or which might not be competitive enough.
Breakeven sales analysis
The breakeven analysis is important when you are in the planning stages of your
business start up. The breakeven analysis tells you how much money you need to make
in sales, daily, weekly or monthly to pay all of your expenses. The point at which all costs
have been accounted for and profits begin to occur is the breakeven point. In assessing
the breakeven point, you are really trying to ascertain how low sales can be before you go
out of business. By preparing the breakeven analysis, you are showing the lender that
you have anticipated the worst, and that you will know when your business is in trouble.
Once calculated, the breakeven point should represent the minimum acceptable sales
level for the first year. It is a floor; and if sales drop below this level you will be loosing
money. Once sales exceed the breakeven point, you begin to make a profit. The lower
you keep your breakeven, the less vulnerable you are. This figure is important when you
are trying to decide whether your business will survive its first (and usually most difficult)
year. It is a signal that warns you of the risk you may be taking. Breakeven sales are
calculated by dividing total expenses (including loan principal payments & depreciation)
by the average projected gross margin % obtained from all sales categories. The formula
for calculation is: “Total Expenses / Gross Margin”.
Return on owner’s investment
The Return on owners’ investment (ROI) is the most common ratio used to determine a
businesses’ profitability. It helps determine the adequacy of owners’ investment plus the
effectiveness of its use. In other words, the return on investment ratio measures the
earning power of the capital that you have invested in your business. It is an overall
indicator of the strength of your business. It is an indication on the rate of return on the
money you will have invested in your business; and should be compared to the rate of
return you might expect on your money if invested elsewhere. It focuses on the
profitability of the overall operation of the firm. Thus, it allows management to measure
the effects of its policies on the firm's profitability. The ROI is the single most important
measure of a firm's financial position and you might say it's the bottom line for the
bottom line. ROI is expressed as a percentage so that it can be compared with other
possible avenues of investment you might be considering. It represents a monetary or
dollar factor. In comparing an investment in your own business with investing in someone
else’s enterprise (e.g. buying stocks or bonds, becoming a silent partner, etc.), there are
factors other than monetary to be considered such as personal independence, challenge,
security, and responsibility. There are several ways to determine ROI, but the easiest
and most popular is to divide net profit by total owners equity.
The formula for calculation is: " Net Income After Tax / Total Owners Equity ". To calculate this for
year two and year three, add the net profit after tax for year one to the owners’ investment
and follow the above calculation. If the return on investment ratio trend is up, it is
favorable, since the ratio provides an overall barometer of the business. If the ratio trend
is down it is unfavorable. A decline indicates problems and you have to ask yourself if
you are getting sufficient return on your investment to be worthwhile. Keep in mind that
the return on investment is not necessarily the same as profit. ROI deals with the money
you as an owner invest in the restaurant and the return you realize on that money based
on the net profit of the business. Profit on the other hand measures the performance of
the business. You can use ROI to measure the performance of your pricing policies, your
inventory investment and so forth.
RATIO CALCULATION FORMULAS
Ratio
Calculation
Cost of Goods Sold (%)
Total Cost of Goods Sold $ / Total Sales $
Gross Margin (%)
Total Gross Margin $ / Total Sales $
Total Expenses to Sales (%)
Total Expense $ / Total Sales $
Net Profit Before Tax to Sales (%)
Net Profit Before Tax $ / Total Sales $
Current Ratio
Current Assets / Current Liabilities
Quick Ratio
(Current Assets- Inventory) / Current Liabilities
Accounts Receivable Collection
Period (Days) Accounts Receivable / (Total
Sales / 365 Days)
Sales to Equity
Total Sales / Total Equity
Fixed Assets to Equity
Total Assets / Total Equity
Current Debt to Equity
Current Liabilities / Total Equity
Total Debt to Equity
(Current Debt + Long Term Debt) / Total Equity
Return on Investment Before Tax
Net Income Before Tax / Total Assets
Return on Owners Equity Before Tax
Net Income Before Tax / (Total Equity +
Shareholder Loans)
Plan Sales Volume
Planned Sales Volume
Breakeven Sales Volume
Total Expenses (incl. depreciation) + LC Interest
+ Loan Principal Payments / Gross Margin %
Average Monthly Breakeven
Sales Volume
Breakeven Sales Volume / 12
Inventory Turnover (Times)
Total Cost of Goods Sold $ / Average Inventory
OTHER INFORMATION
Other information includes topics on:
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Critical issues in manufacturing, retail & service industry
Tips for buying an existing business
Wholesalers / suppliers support services
How to achieve customer satisfaction
Effective merchandising techniques
The importance of an effective sales force
Selling on consignment
Letters of credit