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Financial ratios for companies

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We got you thinking? Worry not! Financial Ratio and Financial Analysis are the two popular ways that help you crack answers to many such business-critical questions. In this article, you will not only learn about financial ratio analysis but also what it means for your company. But before we get to the crux, let us understand what a financial ratio is. Companies big scale or small, financial health is crucial to all, so guess what leads the way to become aware of your financial status?

Financial ratios. Financial ratios, aka Accounting ratios, are the values extracted from a company's financial statements - balance sheet , income statement , cash flow statement , and statement of changes in owner's equity. But what do you do once you have these numerical values? Here is when financial ratio analysis comes to play. The financial ratio alone does not make a very useful story, however once studied and analyzed, it tells you everything you must know about your company.

So, let's take a closer look at financial ratio analysis. Financial Ratio Analysis is evaluating and interpreting the financial statement provided by the company. It takes every numerical value in the financial datasheets, market research, and economic developments into consideration to determine two important aspects of running a business:.

There are different types of financial ratios and their formulas used in financial ratio analysis. Let's try to understand what distinct purposes do these ratios fill. Liquidity ratios measure the ability of a company to pay back long-term as well as short-term debt obligations.

Current Ratio: Measures the ability of a company to return short-term liabilities with current assets. A list of liability and current assets is found easily in your balance sheet, so you can calculate the current ratio using the formula given below. Acid-test Ratio : Measures the ability of a company to repay short-term liabilities with quick assets.

Liquid assets such as cash, accounts receivables, and marketable securities are mainly considered for the acid-test ratio. This leaves out current assets like inventory and prepaid expenses because they are less liquid. Cash Ratio: Measures the ability of a company to pay off short-term liabilities with cash or cash equivalents.

The cash ratio takes the most liquid assets, cash, and marketable securities of the company into consideration. Cash Flow Ratio: Measures the number of times a company can pay off current liabilities with the cash generated in a given time. Leverage ratios measure the amount of capital that comes in the form of debt. It indicates whether the operations of a company, financed using debts or equity. Debt ratio and debt to equity ratio are two ratios one must keep in mind while calculating leverage financial proportions.

Debt Ratio: Measures the relative amount of a company's assets supported from debt. Debt to Equity Ratio: Measures the amount of total debt and financial liabilities opposed to shareholder's proprietorship. Interest Coverage Ratio: Reflects how easily a company can pay off its interest values. Efficiency ratios measure the utilization of resources and assets by a company. Efficiency ratios are of four types:. Asset Turnover Ratio: Measures a company's ability to generate sales from the available assets.

Inventory Turnover Ratio: Calculates the number of times a company's inventory is sold and replaced over a period. Accounts Receivable Turnover Ratio: Calculates the number of times a company can convert receivables into cash in a given time. Days Sales in Inventory Ratio: Calculates the number of days a company holds on to inventory before selling it to customers.

Profitability ratios help measure a company's ability to generate income in relation to revenue. Gross margin ratio, operating margin ratio, return on assets ratio, and return on equity ratio are the four common profitability ratios commonly used. Gross Margin Ratio: Makes a comparison between the gross profit of a company to its sales. This, as a result, reflects upon profit made by a company after paying the cost of goods sold.

The Operating Margin Ratio: A comparison is made between the operating income of a company to its net sales. This, as a result, helps to ascertain the operating efficiency of a company. 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:. A high current ratio may mean that cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment. 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. 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 Doobie Company, we can compute the quick ratio for the company. In general, quick ratios between 0. So the Doobie Company seems to have an adequate quick ratio. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company.

The inventory turnover ratio measures the number of times inventory "turned over" or was converted into sales during a time period. It is also known as the cost-of-sales to inventory ratio. It is a good indication of purchasing and production efficiency. The data used to calculate this ratio come from both the company's income statement and balance sheet.

Here is the formula:. Using the financial statements for the Doobie Company, we can compute the following inventory turnover ratio for the company:. In general, the higher a cost of sales to inventory ratio, the better.

A high ratio shows that inventory is turning over quickly and that little unused inventory is being stored. The sales-to-receivables ratio measures the number of times accounts receivables turned over during the period.

The higher the turnover of receivables, the shorter the time between making sales and collecting cash. A reminder: net sales equals sales less any allowances for returns or discounts. Net receivables equals accounts receivable less any adjustments for bad debts. This ratio also uses information from both the balance sheet and the income statement.

It is calculated as follows:. Using the financial statements for the Doobie Company and assuming that the Sales reported on their income statement is net Sales , we can compute the following sales- to-receivables ratio for the company:. This means that receivables turned over nearly 12 times during the year. This is a ratio that you will definitely want to compare to industry standards. Keep in mind that its significance depends on the amount of cash sales a company has. For a company without many cash sales, it may not be important.

Also, it is a measure at only one point in time and does not take into account seasonal fluctuations. The days' receivables ratio measures how long accounts receivable are outstanding. Business owners will want as low a days' receivables ratio as possible. After all, you want to use your cash to build your company, not to finance your customers.

Also, the likelihood of nonpayment typically increases as time passes. The "" in the formula is simply the number of days in the year. The sales receivable ratio is taken from the calculation we did just a few paragraphs earlier. Using the financial statements for the Doobie Company, we can compute the following day's receivables ratio for the company. This means that receivables are outstanding an average of 31 days.

Again, the real meaning of the number will only be clear if you compare your ratios to others in the industry. The return on assets ratio measures the relationship between profits your company generated and assets that were used to generate those profits. Return on assets is one of the most common ratios for business comparisons.

It tells business owners whether they are earning a worthwhile return from the wealth tied up in their companies. In addition, a low ratio in comparison to other companies may indicate that your competitors have found ways to operate more efficiently. Publicly held companies commonly report return on assets to shareholders; it tells them how well the company is using its assets to produce income. These ratios are of particular interest to bank loan officers.

They should be of interest to you, too, since solvency ratios give a strong indication of the financial health and viability of your business. It shows how much of a business is owned and how much is owed. Using balance sheet data for the Doobie Company, we can compute the debt-to-worth ratio for the company.

If the debt-to-worth ratio is greater than 1, the capital provided by lenders exceeds the capital provided by owners. Bank loan officers will generally consider a company with a high debt-to-worth ratio to be a greater risk. Debt-to-worth ratios will vary with the type of business and the risk attitude of management.

Working Capital Working capital is a measure of cash flow, and not a real ratio. It represents the amount of capital invested in resources that are subject to relatively rapid turnover such as cash, accounts receivable and inventories less the amount provided by short-term creditors.

Working capital should always be a positive number. Lenders use it to evaluate a company's ability to weather hard times. Loan agreements often specify that the borrower must maintain a specified level of working capital. Using the balance sheet data for the Doobie Company, we can compute the working capital amount for the company. Net Sales to Working Capital The relationship between net sales and working capital is a measurement of the efficiency in the way working capital is being used by the business.

It shows how working capital is supporting sales. It is computed as follows:. Using balance sheet data for the Doobie Company and the working capital amount computed in the previous calculation, we compute the net sales to working capital as follows:. Again, this is a ratio that must be compared to others in your industry to be meaningful. In general, a low ratio may indicate an inefficient use of working capital; that is, you could be doing more with your resources, such as investing in equipment.

A high ratio can be dangerous, since a drop in sales which causes a serious cash shortage could leave your company vulnerable to creditors. It's here because it's a bit more complicated to calculate. In return for doing a little more arithmetic, however, you get a number—a Z-Score—which most experts regard as a very accurate guide to your company's financial solvency.

In blunt terms, a Z-Score of 1. One of 2. For a worksheet on calculating your Z-Score. How do your ratios compare to others in your industry? CHECKLIST [ top ] This document has presented information on common size ratios for both the income statement and the balance sheet, plus several additional financial ratios you can use to gain a better understanding of the financial health of your business. The ratios you will use most frequently are common size ratios from the income statement, the current ratio, the quick ratio and return on assets.

Your specific type of business may require you to use some or all of the other ratios as well. Financial ratio analysis is one way to turn financial statements, with their long columns of numbers, into powerful business tools. Financial ratio analysis offers a simple solution to numbers overload. Were liability percentages based on total liabilities plus owners' equity? If not, is there an explanation that is satisfactory to you?

If it is low, or the trend is down for recent years, do you know what changes you need to make? McGraw-Hill, Federal Reserve Bank of New York , Fundamentals of Financial Management , 11th ed. Van Horne and John Martin Wachowicz. Prentice Hall, How to Read and Interpret Financial Statements.

American Management Association , Data for lines of business, sorted by asset size and by sales volume to allow comparisons to companies of similar size in the same industry. The "common size" percentage of total assets or sales is provided for each balance sheet and income statement item. Prentice-Hall, Inc. Information for industries on 22 financial categories. Data is usually three years prior to the publication date.

Financial Research Associates. Industriscope: Comprehensive Data for Industry Analysis. Media General Financial Services. A fill-in-the-blanks calculator for several income and sales ratios. Writer: Alex Auerbach All rights reserved. More than 1, articles can be found in the categories below, addressing timeless challenges faced by entrepreneurs of all types. Financial Ratio Analysis The use of financial ratios is a time-tested method of analyzing a business.

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.

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Financial ratio analysis

1. Current Ratio. Total current assets divided by total current liabilities. 2. Quick Ratio (Acid- Test Ratio).