By Understanding And Applying The Different Business Ratios, Financial Ratios & Ratio Analysis You Are In Control Of Your Business
Business Ratios & Financial Ratios
Business Ratios are mathematical relationships between various balance sheet and income statement items.
Ratio analysis, which relates balance sheet and income statement items to one another, permits the charting of a firms history and the evaluation of its present position. What one ratio will not indicate, another may. Also, a relation vaguely suggested by one ratio may be corroborated by another For these reasons, it is often useful to calculate a number of different ratios; however, in doing the analysis, use only those ratios that are meaningful for the particular company being analyzed.
Four Types of Ratios
Liquidity Ratios - measure firm's ability to meet current obligations
- Current Ratio- CA / CL, should be >1:1 Even if the current ratio appears adequate, a cash shortage could occur if large current liabilities come due before receivables are collected or if current assets are not liquidated at or near their balance sheet values.
- Quick Ratio - indicates firms ability to meet current obligations without liquidating inventory. Important because inventory is the current asset which is most difficult to evaluate and to dispose of merchandise sold on a distressed basis usually brings only a fraction of its purchase or production cost. Also referred to as an acid test.
- Inventory / W.C. - measures how much WIC is invested in inventory; indicates reliance on inventory
- Payable Turnover - average length of time taken to pay trade debt II.
High ratio may indicate:
- Low net W/C
- 2. High inventory
Leverage Ratios - measure the extent to which the firm has been financed by debt
- Total liabilities / N.W. - measures funds contributed by owners versus creditors. The higher the ratio, the smaller the 'cushion provided by the owners' investment.
- Current Liabilities / N.W. - indicates vulnerability. Of the firm to short-term creditor
- F.A ./ N.W. - tends to indicate extent of operational leverage. Higher ratios means higher fixed costs. Higher break-even means a more vulnerable company. Net worth in excess of F.A. is normally available for W.C.
- Miscellaneous Assets / NW. - amount invested in non-operating Assets - investments, affiliates. If significant, indicates funds not available for W.C.
- Total Assets / N.W. - shows % of assets contributed by owners III.
Activity Ratios - measure the effectiveness of a firm in employing resources
- A/R and Inventory Turnover - amount of capital tied up in Uncollected sales and inventory Higher T.O. means longer operating cycle and greater W/C needs
- Longer operating cycle means greater risk. Caution: Inventory T.O. could change if valuation method changes
- Sales / N.W. - Activity level owners are getting of their equity measures effectiveness of utilizing capital base Higher is not necessarily better - could be over-trading indicating under capitalization.
- Sales / F.A. - utilization of F.A. (look for non-capitalized leases)
- Sales / Total Assets - measures the T.O. of all the firm's assets -indicates if the firm is generating a sufficient volume for the size of its asset Investment
- Sales / Working Capital - indicates demands made upon W.C.
Profitability Ratios - measure management's over-all effectiveness as shown by the returns generated on sales and investment
- Gross Margin
- Operating Income / Net Sales
- Operating income / Net Operating Assets -reflects economic productivity of all funds employed in the business, or overall efficiency.
- Profit After Tax / Net Sales
- Profit After Tax / Net Worth - key measure of business profitability - return on equity
Use of Ratios
A ratio is not a meaningful number in and of itself - it must be considered with something before it becomes useful.
The two basic kinds of comparative analysis are:
- Internal Comparison - A trend analysis is done, generally. using the firm's three prior years results. This can give some indication of management and the firms general operating capacity. Historical trends may be useful as a basis for future projections.
- External Comparison - This is a comparison with industry average figures of other firms in the same industry. The industry average is not a magic number which all firms should strive to maintain? In fact, some very well managed firms will be above it, and other good firms will have ratios below the industry average. However, if a firm's ratios are very far removed from the average.
The analyst must be concerned why these variances occur and check further.
- This is best when compared to close competitors which are firms that are similar in terms of size, level of operations, stage of development, accounting methods, management and credit policies, etc.
- Most common source of comparative ratios - Robert Morris Associates annual Statement Studies. These are representative averages based on financial statements received by banks in connection with' loans made.