Financial Ratios

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1. BUSINESS BUILDER 6HOW TO ANALYZE YOUR BUSINESS USING FINANCIAL RATIOS 2. zions business resource center 2 What You Should Know Before Getting Started 4 ã The Purpose…
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  • 1. BUSINESS BUILDER 6HOW TO ANALYZE YOUR BUSINESS USING FINANCIAL RATIOS
  • 2. zions business resource center 2 What You Should Know Before Getting Started 4 • The Purpose of Financial Ratio Analysis 4 • Why Use Financial Ratio Analysis? 5 • Types of Ratios 5 Common Size Ratios 6 • Common Size Ratios from the Balance Sheet 6 • Common Size Ratios from the Income Statement 9 Liquidity Ratios 10 • Current Ratio 10 • Quick Ratio 11 Operating Ratios 12 • Inventory Turnover Ratio 12 • Inventory Days on Hand 13 • Accounts Recievable Turnover Ratio 13 • Accounts Receivable Days on Hand 13 • Accounts Payable Days 14 • Cash Cycle 14 • Return on Assets Ratio 15 how to analyze your business using financial ratios Using a sample income statement and balance sheet, this guide shows you how to convert the raw data on financial statements into information that will help you manage your business.
  • 3. how to analyze your business using financial ratios 3 Solvency Ratios 15 • Debt-to-Worth Ratio 16 • Working Capital 16 • Net Sales to Working Capital 17 • Z-Score 17 Business Ratios 18 Financial Ratio Definitions 19 Checklist 20 Resources 21 Notes 22
  • 4. zions business resource center 4 Many small and mid-sized companies are run by entrepreneurs who are highly skilled in some key aspect of their business, perhaps technology, marketing or sales, but are less savvy in financial matters. The goal of this document is to help you become familiar with some of the most powerful and widely-used tools for analyzing the financial health of your company. Someofthenames,“commonsizeratios”and“liquidityratios,”forexample,maybeunfamiliar. However, nothing in the following pages is actually very difficult to calculate or complicated to use. The payoff can be enormous. The goal of this document is to provide you with some ways to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry. Once you get comfortable with these tools you will be able to turn the raw numbers in your company’s financial statements into information that will help you to better manage your business. what you should know before getting started The Purpose of Financial Ratio Analysis For most of us, accounting is not the easiest thing in the world to understand, and often the terminology used by accountants is part of the problem. “Financial ratio analysis” sounds pretty complicated. In fact, it is not. Think of it as “batting averages for business.” If you want to compare the ability of two Major League home-run sluggers, you are likely to look at their batting averages. If one is hitting .357 and the other’s average is .244, you immediately know which is doing better, even if you don’t know precisely how a batting average is calculated. In fact, this classic sports statistic is a ratio: it’s the number of hits made by the batter, divided by the number of times the player was at bat. (For baseball purists, those are “official at-bats,” which is total appearances at the plate minus walks, sacrifice plays and any time the player was hit by a pitch.) You can think of the batting average as a measure of a baseball player’s productivity; it is the ratio of hits made to the total opportunities to make a hit. Financial ratios measure your company’s productivity. There are many ratios you can use, but they all measure how good a job your company is doing in using its assets, generating profits from each dollar of sales, turning over inventory, or whatever aspect of your company’s operation you are evaluating. what to expect
  • 5. how to analyze your business using financial ratios 5 Why Use Financial Ratio Analysis? The use of financial ratios is a time-tested method of analyzing a business. Wall Street investment firms, bank loan officers and knowledgeable business owners all use financial ratio analysis to learn more about a company’s current financial health as well as its potential. Although it may be somewhat unfamiliar to you, financial ratio analysis is neither sophisticated nor complicated. It is nothing more than simple comparisons between specific pieces of information pulled from your company’s balance sheet and income statement. A ratio, you will remember from school, is the relationship between two numbers. As your math teacher might have put it, it is “the relative size of two quantities, expressed as the quotient of one divided by the other.” If you are thinking about buying shares of a publicly-traded company, you might look at its price-earnings ratio. If the stock is selling for $60 per share, and the company’s earnings are $2 per share, the ratio of price ($60) to earnings ($2) is 30 to 1. In common usage, we would say the “P/E ratio is 30.” Financial ratio analysis can be used in two different but equally useful ways. You can use them to examine the current performance of your company in comparison to past periods of time, from the prior quarter to years ago. Frequently, this can help you identify problems that need fixing. Even better, it can direct your attention to potential problems that can be avoided. In addition, you can use these ratios to compare the performance of your company against that of your competitors or other members of your industry. Remember the ratios you will be calculating are intended simply to show broad trends and thus to help you with your decision-making. They need only to be accurate enough to be useful to you. Don’t get bogged down calculating ratios to more than one or two decimal places. Any change measured in hundredths of a percent will almost certainly have no meaning. Make sure your math is correct, but don’t agonize over it. A ratio can be expressed in several ways. A ratio of two-to-one can be shown as: 2:1 2-to-1 2/1 In these pages, when we present a ratio in the text it will be written out, using the word “to.” If the ratio is in a formula, the slash sign (/) will be used to indicate division. Types of Ratios As you use this guide you will become familiar with the following types of ratios: • Common size ratios • Liquidity ratios • Efficiency ratios • Solvency ratios
  • 6. zions business resource center 6 common size ratios One of the most useful ways for the owner of a small business to look at the company’s financial statements is by using “common size” ratios. Common size ratios can be developed from both balance sheet and income statement items. The phrase “common size ratio” may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total. For example, each of the items on the income statement would be calculated as a percentage of total sales. (Divide each line item by total sales, then multiply each one by 100 to turn it into a percentage.) Similarly, items on the balance sheet would be calculated as percentages of total assets (or total liabilities plus owners’ equity). This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons. If you want to evaluate your cash position compared to the cash position of one of your key competitors, you need more information than what you have, say, $12,000 and he or she has $22,000. That’s a lot less informative than knowing that your company’s cash is equal to 7% of total assets, while your competitor’s cash is 9% of their assets. Common size ratios make comparisons more meaningful; they provide a context for your data. Common Size Ratios from the Balance Sheet To calculate common size ratios from your balance sheet, simply compute every asset category as a percentage of total assets, and every liability account as a percentage of total liabilities plus owners’ equity. Common size ratios make comparisons more meaningful; they provide a context for your data.
  • 7. how to analyze your business using financial ratios 7 Here is what a common size balance sheet looks like for the fictional From the Roots Up Company: Current Assets Cash $223 7.5% Accts/Notes Rec-Trade 884 29.7% Bad Debt Reserve (-) 18 .06% Total Accts/Rec-Net 886 29.1% Accts/Notes Rec-Other 214 7.2% Raw Materials 399 13.4% Finished Goods 497 16.7% Other Inventory 264 8.9% Total Inventory 1,160 39.0% Total Current Assets 2,463 82.8% Non-Current Assets Machinery Equipment 402 13.5% Furniture Fixtures 30 1.0% Leasehold Improvements 28 0.9% Transportation Equipment 92 3.1% Gross Fixed Assets 552 18.6% Accumulated Depreciation (-) 110 3.7% Total Fixed Assets - Net 442 14.9% Operating Non-Current Assets 68 2.3% Total Non-Current Assets 510 17.2% Total Assets 2,973 100.0% Current Liabilities ST Loans Payable-Bank 50 1.7% Accounts Payable-Trade 442 14.9% Wages/Salaries Payable 50 1.7% Non-Op Current Liabilities 231 7.8% Total Current Liabilities 773 26.0% Non-Current Liabilities Long-Term Dept-Bank 400 13.5% Due to Officers/Stakeholders 450 15.1% Total Non-Current Liabilities 850 28.6% Total Liabilities 1,623 54.6% Net Worth Paid in Capital 698 23.5% Retained Earnings 652 21.9% Total Net Worth 1,350 45.4% Total Liabilities Net Worth 2,973 100.0% Working Capital 1,690 56.8% Tang Net Worth-Actual $1,350 45.4% From the Roots Up Company Balance Sheet For the Year Ended December 31, 200X (In Thousands)
  • 8. zions business resource center 8 In the example for From the Roots Up Company, cash is shown as being 7.5% of total assets. The percentage is the result of the following calculation: $223,000 / $2,973,000 x 100 = 7.5% (Multiplying by 100 converts the ratio into a percentage.) Common size ratios translate data from the balance sheet, such as the fact that there is $223,000 in cash, into the information that 7.5% of From the Roots Up Company’s total assets are in cash. Common size ratios are a simple but powerful way to learn more about your business. This type of information should be computed and analyzed regularly. As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities. Receivables should not be tying up an undue amount of company assets. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action. This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers. As this example illustrates, the point of doing financial ratio analysis is not to collect statistics about your company, but to use those numbers to spot the trends affecting your company. Ask yourself why key ratios are up or down compared to prior periods or to your competitors. The answers to those questions can make an important contribution to your decision-making about the future of your company. Current ratio analysis is also a very helpful way for you to evaluate how your company uses its cash. Obviously, it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you. The balance sheet for the From the Roots Up Company shows the company can meet current liabilities. The line item of “total current liabilities,” $773,000, is substantially lower than “total current assets,” $2,463,000. You may wonder, “How do I know if my current ratio is out of line for my type of business?” You can answer this question (and similar questions about any other ratio) by comparing your company with others. You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios. (See the Resources Section at the end of this document.) Because financial ratio comparisons are so important for bank loan officers who make loans to businesses, a bankers’ trade association, Risk Management Association® , has for many years published a volume called “The Annual Statement Studies.” These contain ratios for more than 300 industries, broken down by asset size and sales size. The book is available in most public libraries, or you may ask your banker to obtain the information you need. Another source of information is “Key Business Ratios,” published by Dun and Bradstreet. It is compiled from DB’s vast databases of information on businesses. It lists financial ratios for hundreds ofindustries,andisavailableinmostlocallibraries. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action.
  • 9. how to analyze your business using financial ratios 9 These and other similar publications will give you an industry standard or “benchmark” you can use to compare your firm to others. The ratios described in this guide, and many others, are included in these publications. While period-to-period comparisons based on your own company’s data are helpful, comparing your company’s performance with other similar businesses can be even more informative. Step 1: Compute common size ratios using your company’s balance sheet. Common Size Ratios from the Income Statement To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales. This converts the income statement into a powerful analytical tool. Here is what a common size income statement looks like for the fictional From the Roots Up Company: Common size ratios allow you to begin to make knowledgeable comparisons with past financial statements for your own company and to assess trends, both positive and negative, in your financial statements. Sales/Revenues $8,158 100% Cost of Sales/Revenues 4,895 60% Gross Profit 3,263 40% General Administration Expense 367 4.5% Lease/Rent Expense 188 2.3% Operating Expense 1,468 18% Personnel Expense 816 10% Bad Debt Expense 33 0.4% Total Operating Expense 2,872 35.2% Net Operating Profit 391 4.8% Interest Expense (-) 122 1.5% Total Other Income (exp) (122) (1.5%) Net Profit $269 3.3% From the Roots Up Company Income Statement For the Quarter Ended December 31, 200X (In Thousands)
  • 10. zions business resource center 10 The gross profit margin and the net profit margin ratios are two common size ratios to which small business owners should pay particular attention. On a common size income statement, these margins appear as the line items “gross profit” and “net profit.” For the From the Roots Up Company, the common size ratios show the gross profit margin is 4% of sales. This is computed by dividing gross profit by sales (and multiplying by 100 to create a percentage.) $3,263,000 / $8,158,000 x 100 = 40% Even small changes of 1% or 2% in the gross profit margin can affect a business severely. After all, if your profit margin drops from 5% of sales to 4%, that means your profits have declined by 20%. Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. For example, if profit margins have declined unexpectedly, you probably will want to closely examine all expenses again, using the common size ratios for expense line items to help you spot significant changes. Step 2: Compute common size ratios from your income statement. liquidity ratios Liquidity ratios measure your company’s ability to cover its expenses. The two most common liquidity ratios are the current ratio and the quick ratio. Both are based on balance sheet items. Current Ratio The current ratio is a reflection of financial strength. It is the number of times a company’s current assets exceed its current liabilities, which is an indication of the solvency of the business. Here is the formula to compute the current ratio: Current Ratio = Total current assets / Total current liabilities Using the earlier balance sheet data for the fictional From the Roots Up Company, we can compute the company’s current ratio. From the Roots Up Company Current Ratio: $2,463,000 / $773,000 = 3.19 This tells the owners of the From the Roots Up Company that current liabilities are covered by current assets 3.19 times. The current ratio answers the question, “Does the business have enough current assets to meet the payment schedule of current liabilities with a margin of safety?” Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response.
  • 11. how to analyze your business using financial ratios 11 A common rule of thumb is that a “good” current ratio is 2 to 1. Of course, the adequacy of a current ratio will depend on the nature of the business and the character of the current assets and current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. That’s why a safety margin is needed. A current ratio can be improved by increasing current assets or by decreasing current liabilities. Steps to accomplish an improvement include: • Paying down debt • Acquiring a long-term loan (payable in more than 1 year’s time) • Selling a fixed asset • Putting profits back into the business A high current ratio may mean cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment. Quick Ratio The quick ratio is also called the “acid test” ratio. That’s because the quick ratio looks only at a company’s most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even if adverse conditions occur. Here is the formula for the quick ratio: Quick Ratio = (Total Current Assets - Total Inventory) / Total Current Liabilities Assets considered to be “quick” assets include cash, stocks and bonds, and accounts receivable. In other words, all of the current assets on the balance sheet except inventory. Using the balance sheet data for the From the Roots Up Company, we can compute the quick ratio for the company. Quick ratio for the From the Roots Up Company: ($2,463,000 - $1,160,000) / $773,000 = 1.69 In general, quick ratios between 0.5 and 1 are considered satisfactory, as long as the collection of receivables is not expected to slow. A current ratio can be improved by increasing current assets or by decreasing current liabilities.
  • 12. zions business resource center 12 Step 3: Compute a current ratio and a quick ratio using your company’s balance sheet data. operating ratios There are many types of ratios you can use to measure the efficiency of your company’s operations. In this section we will look at seven that are commonly used and compared. There may be others which are common to a specific industry or that you will create for a specific purpose within your company. These “efficiency ratios” utilize data from both the Balance Sheet and the Profit Loss Statement. The eight ratios we will cover are: • Inventory Turnover Ratio • Inventory Days on Hand • Accounts Receivable Turnover Ratio • Accounts Receivable Days on Hand • Accounts Payable Turnover • Accounts Payable Days • Cash Cycle • Return on Assets Inventory Turnover Ratio The Inventory Turnover Ratio measures the number of times inventory “turned over” or was converted to sales during a time period. It may also be called the Cost of Sales to Inventory Ratio. It is a good indication of purchasing and production efficiency. In general, the higher the ratio, the more frequently the inventory turned over. You might expect a company with a perishable inventory, such as a grocery store, to have a very high Inventory Turnover Ratio. Conversely, a furniture store might have a low Inventory Turnover Ratio. To calculate the ratio we use the formula: Inventory Turnover Rat
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