Amanda Eaves CPA
How many times have you been handed a set of financial statements, told what the numbers are (or were as it mostly happens) and then left with no real understanding of what they really mean? Or even, what is the point?
If you find yourself there, you may find the following financial ratios helpful for gauging past performance and especially planning for future performance. These ratios are used by creditors (in deciding whether to lend you money), vendors (to decide whether to do business with you), and possible investors, to name a few.
The most used ratios fall into four categories: Liquidity, Safety, Profitability, and Efficiency.
Liquidity What is your ability to pay your short term obligations from your current assets?
o Current Ratio = Current Assets / Current Liabilities
- Current assets represent the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business.
- Current liabilities are a company’s debts or obligations that are due within one year
- A current ratio of 1:1 means the company has $1.00 in current assets to cover each $1.00 in current liabilities.
- “You want to see current assets higher than current liabilities, and a current ratio of 2.0 or higher is desirable…anything above 1.0 is considered acceptable. The real test of the current ratio is not today’s ratio but the longer-term trend. You would like to see a consistency over five years or more, in which the ending current ratio is above 1.0.” (from www.mint.com)
o Quick Ratio = (Current Assets less Inventory) / Current Liabilities
- A quick ratio of 1:1 indicates that you can pay the bills with the assets you have, without having to rely on the sale of inventory.
Safety How much of your business was financed through debt and how much was financed through equity?
o Debt-to-Worth Ratio = Debt / Equity
- For this calculation it is common practice to include loans from owners in equity rather than in debt.
- The higher the ratio, the greater the risk to a present or future creditor.
- Most lenders have credit guidelines and limits for the debt-to-equity ratio.
How well does your cash flow cover debt and what is the business’s capacity to take on additional debt?
o Debt Coverage Ratio = Net Income / Debt Payment (Principal & Interest)
- Look for 1.25:1 or better.
Profitability Are your sales increasing with inflation and costs?
o Sales Growth = (Current Year’s Sales less Last Year’s Sales) / Last Year’s Sales
- Provides the percentage increase (or decrease) in sales between two time periods.
- Look for a steady increase in sales.
- If overall costs and inflation are on the rise, then you should watch for a related increase in your sales. If not, then this is an indicator that your prices are not keeping up with your costs.
o Cost of Goods Sold (COGS) to Sales = Cost of Goods Sold / Sales
- Percentage of sales used to pay for expenses which vary directly with sales.
- Look for a stable ratio as an indicator that the company is controlling its gross margins.
o Gross Profit Margin = Gross Profit / Total Sales
- Indicator of how much profit is earned on your products without consideration of selling and administration costs.
- 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?
- Is there a positive gross margin on all your products?
o Net Profit Margin = Net Profit / Total Sales
- Net profit equals the company’s net income after taxes.
- Shows how much profit comes from every dollar of sales.
- 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?
- 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.
o SG&A to Sales = Selling, General & Administrative Expenses / Sales
- Percentage of selling, general and administrative costs to sales
- Look for a steady or decreasing percentage indicating that the company is controlling its overhead expenses
o Return on Equity = Net Profit / Equity
- Determines the rate of return on your investment in the business.
- Are you making enough of a profit to compensate you for the risk of being in business?
- 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.
Efficiency – Also called Asset Management ratios. Indicator of how efficiently the company manages its assets.
o Days in Receivables = Average Accounts Receivable / (Sales x 360 days)
- This calculation shows the average number of days it takes to collect your accounts receivable (number of days of sales in receivables).
- 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. Watch for any changes that might indicate a problem.
o Accounts Receivable Turnover = Net Sales / Average Accounts Receivable
- Number of times that trade receivables turn over during the year.
- The higher the turnover, the shorter the time between sales and collecting cash.
- Compare to industry standards.
o Days in Inventory = Average Inventory / (COGS x 360 days)
- This calculation shows the average number of days it will take to sell your inventory (number of days sales @ cost in inventory).
- Look for trends that indicate a change in your inventory levels.
- Compare the calculated days in inventory to your inventory cycle.
o Inventory Turnover = COGS / Average Total Cost of Inventory
- Number of times that you turn over (or sell) inventory during the year.
- “In most cases, the higher the inventory turnover ratio the better. However, you should try to find the balance between too low and too high of a ratio because both can lead to trouble.” (from blog.fishbowlinventory.com)
o Sales to Total Assets = Sales / Total Assets
- Indicates how efficiently your business generates sales on each dollar of assets.
- A volume indicator that can be used to measure efficiency of your business from year to year.
o Days in Accounts Payable = Average Accounts Payable / COGS x 360 days
- This calculation shows the average length of time your trade payables are outstanding before they are paid.
- Look for trends that indicate a change in your payment habits.
- Compare the calculated days in payables to the terms offered by your suppliers.
- Compare to industry standards.
- Review an Aging of Payables and be familiar with the terms offered by your suppliers.
o Accounts Payable Turnover = COGS / Average Accounts Payable
- The number of times trade payables turn over during the year.
- The higher the turnover, the shorter the time between purchase and payment.
- A low turnover may indicate that there is a shortage of cash to pay your bills or some other reason for a delay in payment.
When looking at your individual ratios you should consider the company’s goals and individual industry trends. It is helpful to compare your ratios to others in your industry, but be careful because not all companies are made the same, and therefore some ratio differences could be misleading. Look for other companies in your industry that are of the same size and in a similar region if possible.
