FINANCIAL RATIOS

Examining these ratios over time provides some insight as to how effectively the business is
being operated. Also, comparing your business to industry averages and quartiles is useful.
Robert Morris & Associates (RMA) is a good source of such comparative financial ratios. BUT
PLEASE REMEMBER THESE ARE ONLY GUIDES THEY ARE NO SUBSTITUTE FOR
STRATEGY.
1. Liquidity: Liquidity measures a company's capacity to pay its debts as they come due.
a. Current Ratio: Total Current Assets / Total Current Liabilities
i. Gauges how capable a business is in paying current liabilities by using
current assets. The actual quality and management of assets must also be
considered.
b. Quick Ratio: (Cash + Accounts Receivable) / Total Current Liabilities
i. Focuses on immediate liquidity. Quick assets are highly liquid and are
immediately convertible to cash. If there are receivable accounts included
in the numerator, they should be collectible.
2. Safety: indicates a company's vulnerability to risk (based on the business' debt).
a. Debt to Equity: Total Liabilities / Total Equity
i. Quantifies the relationship between the capital invested by owners and
investors and the funds provided by creditors. The higher the ratio, the
greater the risk to a current or future creditor. A lower ratio means your
client's company is more financially stable. However, extremely low
indicate too conservative.
b. Interest Coverage Ratio: EBITDA / Interest Expense
i. This assesses the company's ability to meet interest payments. It also
evaluates the capacity to take on more debt. The higher the ratio, the
greater the company's ability to make interest payments/take on debt.
3. Profitability: measures the company's ability to generate a return on its resources.
a. Gross Profit Margin: Gross Profit / Sales
i. Indicates the return at the gross profit level. It addresses three areas -inventory control, pricing and production efficiency. It indicates how
many cents of gross profit generated by sales.
b. Net Profit Margin: Adjusted Net Profit before Taxes / Sales
i. Shows measures how many cents of profit the company generates per
dollar of sales. Track it carefully against industry competitors. This is a
very important number in preparing forecasts.

4. Efficiency: evaluates how well the company manages its assets.

a. Accounts Receivable Turnover: Sales / Accounts receivable
i. Shows the number of times accounts receivable are paid and reestablished
during the accounting period. The higher the turnover, the faster the
business is collecting its receivables and the more cash on hand.
b. Inventory Turnover: COGS / Inventory
i. This ratio shows how many times in one accounting period the company
turns over (sells) its inventory and is valuable for spotting under-stocking,
overstocking, obsolescence and the need for merchandising improvement.
Faster turnovers are generally viewed as a positive trend; they increase
cash flow and reduce warehousing and other related costs.
c. Payroll to Sales: Payroll Expense / Sales
i. This metric shows payroll expense for the company as a percentage of
sales, which indicates the efficiency with which HR is employed.
d. Fixed Asset Turnover: Sales / Gross Fixed Assets
i. This indicator measures how well fixed assets are "throwing off" sales and
is very important to businesses that require significant fixed assets.
e. Return on Assets: Net Income / Total Assets
i. Measures the company's ability to use its assets to create profits. ROA
indicates how many cents of profit each dollar of asset is producing per
year. It indicates how managers use the assets available to them.
f. Return on Equity: Net Income / Total Equity
i. Determines the rate of return on the invested capital. It is used to compare
investment in the company against other investment opportunities, such as
stocks, real estate, savings, etc. There should be a direct relationship
between ROI and risk (i.e., the greater the risk, the higher the return).