We’re having fun now, huh? We have covered the basic groundwork on the nature of your company’s financial statements, and the statements significance. Ratios have the ability to expose your company’s many strengths and weaknesses in relation to other companies in your industry.
How about we take a look at ratios?
Ratio analysis is the most objective way for you to evaluate your financial statements, and the relationship between the statements. As a matter of fact, particular values are taken from one statement and plugged into another – such as in the case of “sales revenue”. The final calculation of “sales revenue” is taken from the income statement and placed in the statement of cash flows under cash flows from operating activities.
Because of the relationship among the three financial statements (income statement, balance sheet and statement of cash flows), you can take various values from your financial statements and determine how your company is financially performing and determine areas of improvement.
Keep in mind once you have determined your ratios, it is very important that you follow this up with comparing your ratios with your company’s past performance and against the industry average. This will be the true acid test to how your firm is performing.
Let’s take a look at a few common ratios that you could use right now. These ratios will show you areas of solvency to areas of operational efficiency. I will be presenting the following ratios “for your dining and dancing pleasure”:
- Current ratio
- Quick ratio
- Inventory turnover ratio
- Days sales outstanding (DSO) ratio
- Operating profit margin after taxes ratio
- Return on total assets (ROA) ratio
The current ratio is a popular financial ratio used to test a company’s liquidity by deriving the proportion of current assets available to cover current liabilities.
The concept behind this ratio is so you can determine whether your company’s short-term assets are readily available to pay off short-term liabilities.
Short-term assets are:
- Cash equivalents
- Marketable securities
Short-term liabilities are:
- Notes payable
- Current portion of term debt
- Accrued expenses
Common wisdom holds that the higher the current ratio, the better.
Current Ratio = Current Assets/Current Liabilities
Current assets and current liabilities can be located on your company’s balance sheet, and you will find them labeled as such.
Current Ratio = $1,575.6/$606.9 = 2.6
What does 2.6 represent in realistic terms? The 2.6 in this case means that the firm has the ability to pay short-term liabilities twice over. Depending on the industry average for your type of business, this ratio will help you see how you are performing against your competition.
The quick ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. Put another way, this particular ratio offers a better perspective on the cash position of your business by eliminating the “maybe-not-so-quickly-liquidated” current assets. Therefore this ratio eliminates inventory from current assets. Think of this ratio as show your firm’s ability to still pay bills even if inventory does not sell.
The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.
Quick Ratio = Cash & Equivalents + Short-term Investments +Acct. Receivable/Current Liabilities
Quick Ratio = $233.2 + 524.2/$606.9 = 1.3
As you can see in this case the 1.3 indicates that you are able to pay off any current bills, with just a little bit of a cushion.
Inventory Turnover ratio
You in the service-industry can just move along past this ratio. This ratio is not applicable to you. For those who deal in selling product, then by all means read on!
Inventory turnover ratio shows how many times your company’s inventory is sold and replaced over a given period. In other words, this ratio measures the time frame between the acquisition of inventory and the sale of the inventory. It’s pretty straight-forward.
Generally calculated as:
Inventory Turnover ratio = Sales / Inventory
Inventory Turnover ratio = $3,000 / $615 = 4.9 times
Industry average = 9.0 times
Or it may be calculated as:
Inventory Turnover ratio = Cost of Goods Sold/Average Inventory
The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or “inventory turnover days”.
Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors.
Your inventory turnover ratio is an excellent way of indicating how effectively your company uses inventory. This ratio should be compared against industry averages. As a matter of fact, that is true with all ratios. You can see in the example above that the firm’s numbers (4.9 times) indicate that they are not performing up to the industry average which is 9 times. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. As I said you want a high inventory turnover ratio, right? Check this out…the higher the turnover, the less money is tied up in inventory in order to fill your “oh-so-important” distribution channels. This translates into more resources available for marketing, R&D, acquisitions, advertising and so on.
Beware – high inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.
Day sales outstanding (DSO) ratio
This is a measure of the average number of days that a company takes to collect revenue after a sale has been made. This ratio is also called average collection period. A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.
DSO is calculated as:
DSO = Accounts Receivable / Total Credit Sales x Number of Days
Or it may be calculated as:
DSO = Accounts Receivable / (Total Credit Sales/Number of Days)
DSO = $375 / ($3,000 / 360) = $375 / $8.333 = 45 days
Industry average = 36 days
Due to the high importance of cash in running your business, it is in your company’s best interest to collect outstanding receivables as quickly as possible. By quickly turning sales into cash, a company has the chance to put the cash to use again – ideally, to reinvest and make more sales. The DSO can be used to determine whether a company is trying to disguise weak sales, or is generally being ineffective at bringing money in. For most businesses, DSO is looked at either quarterly or annually. As you can see in the example it is taking the hypothetical company 45 days to receive payment for inventory sold. This is not good especially when it is compared to the industry average of 36 days.
Operating Profit Margin Ratio
This ratio measures your company’s pricing strategy and operating efficiency. Profit margin is an excellent method to determine your company’s bottom line. Do you want to know how much of each dollar is available to your business? Then this is the ratio for you.
Operating Profit Margin = Operating Income / Net Sales
Operating Profit Margin = $1,800 / $3,000 = 60%
Industry average = 50.3%
Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The above example indicates that the hypothetical firm is above the industry average with a 60% profit margin. This means that this particular company is making 60 cents on every dollar…that’s not too shabby!
Also known as “operating profit margin” or “net profit margin”.
Here’s a free tip for you – if your company has a low profit margin, the margin may be improved by increasing your inventory turnover ratio.
See, I told you this “stuff” is interrelated.
Return on total assets (ROA) ratio
ROA = Net Income / Total Assets
ROA = $113.5 / $2,000 = 5.7%
Industry average = 9%
Return on Assets Analysis:
So, your company wants to embark on a new project? ROA is an important ratio for companies deciding whether or not to initiate new projects. The basis of this ratio is that if a company is going to start a project they expect to earn a return on it, ROA is the return your company should expect to receive. Simply put, if ROA is above the financing rate that the company is paying then the project should be accepted, if not then it is rejected. I told you it was simple…to make the project worth it to your firm, the rate of return MUST be higher than your financing rate for the project. Unless you are crazy, and like the thought of losing money…you will always take ROA/ROI into account.
ROA indicates what return your companyis generating on the firm’s investments/assets. Taking the above findings into consideration, you can see that the fictitious company’s ratio of 5.7% is well below the industry average…being well out-paced by the industry average of 9%. This company could do with improving the return on assets or they won’t be around very long.
Keep these things in mind…
- The ROA is often referred to as Return on Investment (ROI)
- The interest expense is added to ignore the costs associated with funding those assets.