Financial ratios illustrate relationships between different aspects of a business's operations. They involve the comparison of elements from a balance sheet or income statement, and are crafted with particular points of focus in mind. Financial ratios can provide managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful way to identify trends as they develop. Ratios are also used by bankers, investors, and business analysts to assess various attributes of a company's financial strength or operating results.
Ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable managers to examine the relationships between seemingly unrelated items and thus gain useful information for decision making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," James 0. Gill noted in his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future."
Virtually any financial statistics can be compared using a ratio. In reality, however, managers need to be concerned only with a small set of ratios in order to identify where improvements are needed. "As you run your business you juggle dozens of different variables," David H. Bangs Jr. wrote in his book Managing by the Numbers. "Ratio analysis is designed to help you identify those variables which are out of balance."
It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the business at the time that the underlying figures were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, ratios can be misleading when taken singly, though they can be quite valuable when a business tracks them over time or uses them as a basis for comparison against company goals or industry standards. As a result, managers should compute a variety of applicable ratios and attempt to discern a pattern, rather than relying on the information provided by only one or two ratios. Gill also noted that business managers should be certain to view ratios objectively, rather than using them to confirm a particular strategy or point of view.
Perhaps the best way for managers to use financial ratios is to conduct a formal ratio analysis on a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant. In general, financial ratios can be broken down into four main categories—profitability or return on investment, liquidity, leverage, and operating or efficiency—with several specific ratio calculations prescribed within each.
Profitability ratios provide information about management's performance in using the resources of the business. It is important to note, however, that many factors can influence profitability ratios, including changes in price, volume, or expenses, as well the purchase of assets or the borrowing of money. Some specific profitability ratios follow, along with the means of calculating them and their meaning to a business manager.
Gross Profits/Net Sales: measures the margin on sales the company is achieving. It can be an indication of manufacturing efficiency, or marketing effectiveness.
Net Income/Net Sales: measures the overall profitability of the company, or how much is being brought to the bottom line. Strong gross profitability combined with weak net profitability may indicate a problem with indirect operating expenses or nonoperating items, such as interest expense. In general terms, net profitability shows the effectiveness of management. Though the optimal level depends on the type of business, the ratios can be compared for firms in the same industry.
Net Income/Total Assets: indicates how effectively the company is deploying its assets. A very low return on assets (ROA) usually indicates inefficient management, whereas a high ROA means efficient management. This ratio can be distorted, however, by depreciation or any unusual expenses.
Net Income/Owners' Equity: indicates how well the company is utilizing its equity investment. Due to leverage, this measure will generally be higher than return on assets. Return on investment (ROI) is considered to be one of the best indicators of profitability. It is also a good figure to compare against competitors or an industry average. Experts suggest that companies usually need at least 10 to 14 percent ROI in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROI can mean that management is doing a good job, or that the firm is undercapitalized.
Dividends +/Stock Price Change/Stock Price Paid: from the investor's point of view, this calculation of ROI measures the gain (or loss) achieved by placing an investment over time.
Net Income/Number of Shares Outstanding: states a corporation's profits on a per share basis. It can be helpful in further comparison to the market price of the stock.
Net Sales/Total Assets: measures a company's ability to use assets to generate sales. Although the ideal level for this ratio varies greatly, a very low figure may mean that the company maintains too many assets or has not deployed its assets well, whereas a high figure means that the assets have been used to produce good sales numbers.
Total Sales/Number of Employees: can provide a measure of productivity, though a high figure can indicate either good personnel management or good equipment.
Liquidity ratios demonstrate a company's ability to pay its current obligations. In other words, they relate to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. All businesses require a certain degree of liquidity in order to pay their bills on time, though start up and very young companies are often not very liquid. In mature companies, low levels of liquidity can indicate poor management or a need for additional capital. Any company's liquidity may vary due to seasonality, the timing of sales, and the state of the economy. But liquidity ratios can provide business managers with useful limits to help them regulate borrowing and spending. Some of the best-known measures of a company's liquidity follow.
Current Assets/Current Liabilities: measures the ability of an entity to pay its near-term obligations. "Current" usually is defined as within one year. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business.
Quick Assets (cash, marketable securities, and receivables)/Current Liabilities: provides a stricter definition of the company's ability to make payments on current obligations. Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poor collection program for accounts receivable. If it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations.
Cash/Total Assets: measures the portion of a company's assets held in cash or marketable securities. Although a high ratio may indicate some degree of safety from a creditor's viewpoint, excess amounts of cash may be viewed as inefficient.
Net Sales/Accounts Receivable: measures the annual turnover of accounts receivable. A high number reflects a short lapse of time between sales and the collection of cash, while a low number means collections take longer. It is best to use average accounts receivable to avoid seasonality effects.
365/Sales to receivables ratio: measures the average number of days that accounts receivable are outstanding. This number should be the same or lower than the company's expressed credit terms. Other ratios can also be converted to days, such as the cost of sales to payables ratio.
Cost of Sales/Trade Payables: measures the annual turnover of accounts payable. Lower numbers tend to indicate good performance, though the ratio should be close to the industry standard.
Net Sales/Net Working Capital (current assets less current liabilities): reflects the company's ability to finance current operations, the efficiency of its working capital employment, and the margin of protection for its creditors. A high cash turnover ratio may leave the company vulnerable to creditors, while a low ratio may indicate an inefficient use of working capital. In general, sales five to six times greater than working capital are needed to maintain a positive cash flow and finance sales.
Leverage ratios look at the extent to which a company has depended upon borrowing to finance its operations. As a result, these ratios are reviewed closely by bankers and investors. Most leverage ratios compare assets or net worth with liabilities. A high leverage ratio may increase a company's exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns. Some of the major measurements of leverage follow.
Debt/Owners' Equity: indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity.
Debt/Total Assets: measures the portion of a company's capital that is provided by borrowing. A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. This ratio is similar, and can easily be converted to, the debt to equity ratio.
Net Fixed Assets/Tangible Net Worth: indicates how much of the owners' equity has been invested in fixed assets, i.e., plant and equipment. It is important to note that only tangible assets are included in the calculation, and that they are valless depreciation. Creditors usually like to see this ratio very low, but the large-scale leasing of assets can artificially lower it.
Earnings before Interest and Taxes/Interest Expense: indicates how comfortably the company can handle its interest payments. In general, a higher interest coverage ratio means that the small business is able to take on additional debt. This ratio is closely examined by bankers and other creditors.
By assessing a company's use of credit, inventory, and assets, efficiency ratios can help managers conduct business better. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given period. This information can help management decide whether the company's credit terms are appropriate and whether its purchasing efforts are handled in an efficient manner. Following are some of the main indicators of efficiency.
Cost of Goods Sold for the Year/Average Inventory: shows how efficiently the company is managing its production, warehousing, and distribution of product, considering its volume of sales. Higher ratios—over six or seven times per year—are generally thought to be better, although extremely high inventory turnover may indicate a narrow selection and possibly lost sales. A low inventory turnover rate, on the other hand, means that the company is paying to keep a large inventory, and may be overstocking or carrying obsolete items.
365/Annual Inventory Turnover: calculates the number of days, on average, that elapse between finished goods production and sale of product.
Inventory/Total Assets: shows the portion of assets tied up in inventory. Generally, a lower ratio is considered better.
Net (Credit) Sales/Average Accounts Receivable: gives a measure of how quickly credit sales are turned into cash. Alternatively, the reciprocal of this ratio indicates the portion of a year's credit sales that are outstanding at a particular time.
365/Accounts Receivable Turnover: measures the average number of days the company's receivables are outstanding, between the dates of credit sale and collection of cash.
Although they may seem intimidating at first glance, all of the aforementioned financial ratios can be derived by simply comparing numbers that appear on a business's income statement and balance sheet. As Gill noted, business owners and managers would be well-served to "think of ratios as one of your best friends when scrutinizing your business."
Financial ratios can be an important tool for managers to measure their progress toward reaching company goals, as well as toward competing with other companies within an industry. Ratio analysis, when performed regularly, can also help businesses recognize and adapt to trends affecting their operations. Yet another reason managers need to understand financial ratios is that they provide one of the main measures of a company's success from the perspective of bankers, investors, and business analysts. Often, a business's ability to obtain debt or equity financing will depend on the company's financial ratios.
Despite all the positive uses of financial ratios, however, managers are still encouraged to know the limitations of ratios. As Gill explained, "[Ratios] do not make decisions for you, but will provide information from which decisions may be made." It is important to remember that the numbers used to compute financial ratios are based on assumptions and varying accounting principles. In addition, no standard definitions exist for financial ratios, so two companies may arrive at their numbers differently. "Because of these potentially very material differences, we are forced to conclude that companies in the same sector can have wildly varying ratios for reasons other than genuine differences in economic performance," Marc Gardiner and Katherine Bagshaw noted in Management Accounting. So while ratio analysis can be a valuable tool for business managers and other professionals, it should always be approached with a degree of caution.
[ Christopher C. Barry ,
updated by Laurie Collier Hillstrom ]
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