Essay: Financial ratios and quality indicators

LIQUIDITY.

Financial ratios in this category measure the company’s capacity to pay its debts as they come due.

Definition:

The ratio between all current assets and all current liabilities; another way of expressing liquidity.

Formula:

Current Assets
Current Liabilities

Analysis:

1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible.
ne problem with the current ratio is that it ignores timing of cash received and paid out. For example, if all the bills are due this week, and inventory is the only current asset, but won’t be sold until the end of the month, the current ratio tells very little about the company’s ability to survive.

Definition:

The ratio between all assets quickly convertible into cash and all current liabilities. Specifically excludes inventory.

Formula:

Cash + Accounts Receivable
Current Liabilities

Analysis:

Indicates the extent to which you could pay current liabilities without relying on the sale of inventory — how quickly you can pay your bills. Generally, a ratio of 1:1 is good and indicates you don’t have to rely on the sale of inventory to pay the bills.
Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments.

FINANCIAL CONDITION.

Indicator of the businesses’ vulnerability to risk. These ratios are often used by creditors to determine the ability of the business to repay loans.

Definition:

Shows the ratio between capital invested by the owners and the funds provided by lenders.

Formula:

Debt
Equity

Analysis:

Comparison of how much of the business was financed through debt and how much was financed through equity. For this calculation it is common practice to include loans from owners in equity rather than in debt.
he higher the ratio, the greater the risk to a present or future creditor.
ook for a debt to equity ratio in the range of 1:1 to 4:1
Most lenders have credit guidelines and limits for the debt to equity ratio (2:1 is a commonly used limit for small business loans).
Too much debt can put your business at risk… but too little debt may mean you are not realizing the full potential of your business — and may actually hurt your overall profitability. This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate). If you think that you might be in this situation, talk to your accountant or financial advisor.

Definition:

Indicates how well your cash flow covers debt and the capacity of the business to take on additional debt.

Formula:

Net Profit + Non-cash expenses
Debt

Analysis:

hows how much of your cash profits are available to repay debt.
enders look at this ratio to determine if there is adequate cash to make loan payments.
Most lenders also have limits for the debt coverage ratio.

PROFITABILITY.

The ratios in this section measure the ability of the business to make a profit.

Definition:

Indicator of how much profit is earned on your products without consideration of selling and administration costs.

Formula:

Gross Profit
Total Sales

where Gross Profit = Sales less Cost of Goods Sold

Analysis:

Compare to other businesses in the same industry to see if your business is operating as profitably as it should be.
Look at the trend from month to month. Is it staying the same? Improving? Deteriorating?
Is there enough gross profit in the business to cover your operating costs?
s there a positive gross margin on all your products?

Definition:

Shows how much profit comes from every dollar of sales.

Formula:

Net Profit
Total Sales

Analysis:

Compare to other businesses in the same industry to see if your business is operating as profitably as it should be.
ook at the trend from month to month. Is it staying the same? Improving? Deteriorating?
Are you generating enough sales to leave an acceptable profit?
Trend from month to month can show how well you are managing your operating or overhead costs.

Definition:

Determines the rate of return on your investment in the business. As an owner or shareholder this is one of the most important ratios as it shows the hard fact about the business — are you making enough of a profit to compensate you for the risk of being in business?

Formula:

Net Profit
Equity

Analysis:

Compare the return on equity to other investment alternatives, such as a savings account, stock or bond.
Compare your ratio to other businesses in the same or similar industry.

Definition:

Considered a measure of how effectively assets are used to generate a return. (This ratio is not very useful for most businesses.)

Formula:

Net Profit
Total Assets

Analysis:

ROA shows the amount of income for every dollar tied up in assets.
Year to year trends may be an indicator … but watch out for changes in the total asset figure as you depreciate your assets (a decrease or increase in the denominator can effect the ratio and doesn’t necessarily mean the business is improving or declining.

EFFICIENCY.

Also called Asset Management ratios. Indicator of how efficiently the company manages its assets.

Definition:

This calculation shows the average number of days it takes to collect your accounts receivable (number of days of sales in receivables).

Formula:

Average Accounts Receivable
Sales X 360 days

Analysis:

Look for trends that indicate a change in your customers’ payment habits.
Compare the calculated days in receivables to your stated terms.
Compare to industry standards.
Review an Aging of Receivables and be familiar with your customers payment habits and watch for any changes that might indicate a problem.

Definition:

Number of times that trade receivables turnover during the year.

Formula:

Net Sales
Average Accounts Receivable

Analysis:

The higher the turnover, the shorter the time between sales and collecting cash.
Compare to industry standards.

Definition:

Number of times that you turn over (or sell) inventory during the year.

Formula:

Cost of Goods Sold
Average Inventory

Analysis:

Generally, a high inventory turnover is an indicator of good inventory management.
But a high ratio can also mean there is a shortage of inventory.
A low turnover may indicate overstocking, or obsolete inventory.
Compare to industry standards.

Definition:

Indicates how efficiently your business generates sales on each dollar of assets.

Formula:

Sales
Total Assets

Analysis:

volume indicator that can be used to measure efficiency of your business from year to year.