The Balance Sheet and the Statement of Income are essential, but they are only the starting point for successful
financial management. Apply
Ratio Analysis to Financial Statements to analyze the success, failure, and progress
Balance Sheet Ratio Analysis
Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its bills as they come
due) and leverage (the extent to which the business is dependent on creditors' funding). They include the following
ratios:
Liquidity Ratios
These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working
Capital.
Current Ratios
The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:
Current Ratio = Total Current Assets / Total Current Liabilities
The main question this ratio addresses is: "Does your business have enough current assets to meet the payment
schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory
shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio
is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The
minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.
If you feel your business's current ratio is too low, you may be able to raise it by:
Paying some debts.
Increasing your current assets from loans or other borrowings with a maturity of more than one year.
Converting non-current assets into current assets.
Increasing your current assets from new equity contributions.
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Putting profits back into the business.
Quick Ratios
The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is figured as
shown below:
Quick Ratio = Cash + Government Securities + Receivables / Total Current Liabilities
The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates
on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all sales revenues should
disappear, could my business meet its current obligations with the readily convertible `quick' funds on hand?"
An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts receivable,
and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.
Working Capital
Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number.
It is calculated as shown below:
Working Capital = Total Current Assets - Total Current Liabilities
Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are
often tied to minimum working capital requirements.
A general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are
relying to any significant extent on creditor money to finance assets.
Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor
money versus owner's equity):
Debt/Worth Ratio = Total Liabilities / Net Worth
Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it
correspondingly harder to obtain credit.
Income Statement Ratio Analysis
The following important State of Income Ratios measure profitability:
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Gross Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures
the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the
overhead expenses of the company.
Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in
your business. The Gross Margin Ratio is calculated as follows:
Gross Margin Ratio = Gross Profit / Net Sales
Reminder: Gross Profit = Net Sales - Cost of Goods Sold
Net Profit Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except
income taxes. It provides a good opportunity to compare your company's "return on sales" with the performance of
other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from
company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net
Profit Margin Ratio is calculated as follows:
Net Profit Margin Ratio = Net Profit Before Tax / Net Sales
Management Ratios
Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement
of Income information.
Inventory Turnover Ratio
This ratio reveals how well inventory is being managed. It is important because the more times inventory can be
turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:
Inventory Turnover Ratio = Net Sales / Average Inventory at Cost
Accounts Receivable Turnover Ratio
This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in
accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in
being converted to cash, liquidity could be severely impaired. Getting the Accounts Receivable Turnover Ratio is a two
step process and is is calculated as follows:
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Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)
Accounts Receivable Turnover (in days) = Accounts Receivable / Daily Credit Sales
Return on Assets Ratio
This measures how efficiently profits are being generated from the assets employed in the business when compared
with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient
use of business assets. The Return on Assets Ratio is calculated as follows:
Return on Assets = Net Profit Before Tax / Total Assets
Return on Investment (ROI) Ratio
The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by
its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If
the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the
owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles
of small business management. The ROI is calculated as follows:
Return on Investment = Net Profit before Tax / Net Worth
These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a
business and to compare its progress with the performance of others through data published by various sources. The
owner may thus determine the business's relative strengths and weaknesses.
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of your business.
Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance
and condition with the average performance of similar businesses in the same industry. To do this compare your
ratios with the average of businesses similar to yours and compare your own ratios for several successive years,
watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early
warning indications that allow you to solve your business problems before your business is destroyed by them.