Key Business and Financial Ratios
Business and financial ratios are mathematical relationships between various balance sheet and income statement items. Applying these different business and financial ratios will help you better understand your business and with all your business acquisition activities.
Business and Financial Ratios
Ratio analysis connects the balance sheet and income statement items to one another, allowing the charting of a firm’s history and the analysis of its current financial position. It is important to look at a number of different financial ratios. Be sure to ratios that are relevant to the specific company being studied.
Four Types of Ratios
Liquidity Ratios – measure firm’s ability to meet current obligations
A. Current Ratio – CA / CL, should be >1:1 Even if the current ratio seems 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.
B. Quick Ratio – indicates firm’s ability to meet its current obligations without selling off or liquidating inventory. Looking at Quick Ratio is important because inventory is the current asset that is most difficult to evaluate. Disposing of inventory in a distressed effort basis typically brings in only a fraction of its typical, normal consumption use. This is what is also referred to as the Acid Test.
C. Inventory / Working Capital – measures how much is invested in inventory; it shows the degree of reliance the business has on inventory
D. Payable Turnover – average length of time taken to pay trade debt.
High ratio may indicate:
- Low net W/C
- High inventory
Leverage Ratios – measure the extent to which the firm has been financed by debt
A. Total Liabilities / Net Worth (NW) – show the amount of funds provided by owners compared to funds provided by creditors. The higher the ratio, the smaller the “cushion provided by the owner’s” investment of funds.
B. Current Liabilities / Net Worth (NW) – indicates vulnerability of the firm to its short-term creditor
C. F.A . / Net Worth (NW) – indicates the extent of operational leverage. Higher ratios means higher fixed costs. Higher break-even means the business has a higher level of vulnerability. Net worth in excess of F.A. is normally available for W.C.
D. Miscellaneous Asset / Net Worth (NW) – the amount invested in non-operating Assets – investments, affiliates. If significant, indicates funds not available for W.C.
E .Total Assets / Net Worth (NW) – is % of assets contributed by owners.
Activity Ratios – These ratios measure the effectiveness of a firm’s ability to apply its resources
A. Accounts Receivable (A/R) and Inventory Turnover (T.O.) – amount of capital tied up in Uncollected Sales and Inventory. A higher turn over means longer operating cycle and greater W.C. needs
B. Longer operating cycle means greater risk. Caution: Inventory T.O. could change if valuation method changes
C. Sales / Net Worth (NW) – 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.
D. Sales / Fixed Assets – utilization of F.A. (look for non-capitalized leases)
E. 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
F. Sales / Working Capital – indicates demands made upon Working Capital
Profitability Ratios – measure management’s over-all effectiveness as shown by the returns generated on sales and investment
A. Gross Margin
B. Operating Income / Net Sales
C. Operating income / Net Operating Assets – reflects economic productivity of all funds employed in the business, or overall efficiency.
D. Profit After Tax / Net Sales
E. Profit After Tax / Net Worth – this is a 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:
I. Internal Comparison – A trend analysis is done generally using the firm’s three prior years’ results. This give an indication of management and the firms general operating capacity. Historical trends may be useful as a basis for future projections.
II. 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.
A. 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.
B. 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.