Business financial ratios (also called financial operating ratios) are used to measure a business’s condition and performance. Using data from your company’s balance sheet and income statements, various ratios can be calculated and compared with ratios of businesses like yours to see where you stand. These indicators allow you to evaluate your business’s condition and performance, and to implement improvements where ratios are weak.
There are four categories of ratios. Liquidity ratios measure your company’s short-term ability to pay its maturing obligations. Activity ratios measure how effectively your company is using its assets. Profitability ratios measure the degree of success or failure of your company during a given period of time. Coverage ratios measure the degree of protection for long-term creditors and investors.
You should examine your business ratios on a regular basis to ensure that your business is operating as well as, or better than, others in your industry.
Caution: Once identified (which is at least a good start), business ratios generally take one or more years to improve. This is something to keep in mind if you anticipate selling your business soon or will be looking for financing. Prospective buyers, creditors, and investors will certainly be interested in your business ratios.
Significant Liquidity Ratios
Current Ratio
This equals current assets divided by current liabilities. It is a measure of liquidity; the higher the ratio, the greater the likelihood that current liabilities can be paid.
Acid-Test Ratio
This is a test to determine liquidity by dividing the most current assets (cash, marketable securities, and accounts receivable) by current liabilities. In general, the ratio should at least be equal to one. For example, assume cash is $100, accounts receivable is $1,100, and accounts payable is $1,000. The acid-test ratio equals 1.2 (100 + 1,100 divided by 1,000).
Cash-to-Current-Liabilities Ratio
This is a computation that measures a company’s ability to satisfy short-term financial obligations immediately, and is therefore a good liquidity measure. The ratio equals cash plus near-cash and marketable securities divided by current liabilities.
Cash-Flow-to-Total-Debt Ratio
This is the rate indicating a company’s ability to satisfy its debts. It is useful in predicting bankruptcy. The ratio equals cash flow from operations divided by liabilities.
Significant Activity Ratios
Inventory Turnover Ratio
This equals the cost of goods sold divided by the average inventory. Average inventory equals beginning inventory plus ending inventory divided by two. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances, a low rate may be appropriate, such as when higher inventory levels occur in anticipation of rapidly rising prices or shortages. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss of business.
Receivables Turnover Ratio
This ratio is computed by dividing net sales by average receivables outstanding during the year. This information provides some indication of the quality of the receivables and also an idea of how successful your company has been in collecting its outstanding receivables.
Asset Turnover Ratio
This is determined by dividing average total assets into net sales for the period. This ratio supposedly indicates how efficiently your company utilizes its assets. If the ratio is high, your company is using its assets effectively to generate sales. If the ratio is low, your company either has to use its assets more efficiently or dispose of them.
Significant Profitability Ratios
Profit Margin on Sales Ratio
This ratio is computed by dividing net income by net sales for the period. This ratio indicates what rate your company is achieving on each sales dollar it receives.
Return on Assets Ratio
This is a measure of the earning power of assets. The ratio reveals the firm’s profitability on its business operations and thus serves to measure management’s effectiveness. It equals net income divided by average total assets. Other variations also exist, such as net income before interest and taxes divided by average total assets.
Return on Common Stock Equity Ratio
This ratio is defined as net income divided by average common stockholder’s equity. When the rate of return on total assets is lower than the rate of return on stockholder’s equity, your company is said to be trading on the equity at a gain. Trading on equity increases your company’s financial risk.
Significant Coverage Ratios
Debt-to-Equity Ratio
This equals total liabilities divided by total equity. A high ratio indicates that the business has a lot to risk. Potential creditors are reluctant to give financing to a company with a high debt position.
Cash-Flow-to-Capital-Expenditures Ratio
This is a computation indicating a company’s ability to maintain plant and equipment from cash provided by operations, rather than by borrowing or issuing new stock. The ratio equals cash flow from operations, less dividends, divided by expenditures for plant and equipment.
Creditor’s Equity Ratio
This equals total liabilities divided by total assets, and reflects the percentage of assets financed by creditors. In the event of corporate liquidation, creditors are paid before stockholders.
Fixed-Asset-to-Equity Capital Ratio
This equals fixed assets divided by equity capital and indicates the company’s ability to satisfy long-term debt. A ratio greater than one means that some of the fixed assets are financed by debt.
Limitations to Ratio Analysis
Because you can compute business ratios precisely, you may be tempted to give their results a high degree of reliability and significance. Before you do so, you should keep the following points in mind.
Ratios are based on historical cost, leading to distortions in measuring performance. You may get an inaccurate assessment of your company’s financial condition because assets are generally on the company’s books at historical cost. Be sure to take changing prices into consideration.
Income ratios lose credibility when depreciation and amortization are used. Because some expenses are merely approximations (e.g., bad debts, depreciation, and amortization), net income cannot be precisely measured. Remember that net income is an abstraction to a certain extent.
Comparability to other firms in the industry is imprecise. Different firms use different accounting methods (e.g., inventory valuation methods, and depreciation methods). This can result in staggering differences in income, depending on what methods are used. Also, other firms experience the same distortions that your firm experiences. You should be aware of these potential pitfalls when comparing your company’s ratios with those of others in your industry.
If you have questions, contact the Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
