Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy. Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used: Liquidity ratios Asset turnover ratios Financial leverage ratios Profitability ratios Dividend policy ratios Liquidity Ratios Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio. The current ratio is the ratio of current assets to current liabilities: Current Assets Current Ratio = Current Liabilities Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows: Current Assets - Inventory Quick Ratio = Current Liabilities The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test. Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is defined as follows: Cash + Marketable Securities Cash Ratio = Current Liabilities The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason immediate payment were demanded. Asset Turnover Ratios Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover. Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows: Annual Credit Sales Receivables Turnover = Accounts Receivable The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows: Accounts Receivable Average Collection Period = Annual Credit Sales / 365 The collection period also can be written as: 365 Average Collection Period = Receivables Turnover

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period: Cost of Goods Sold Inventory Turnover = Average Inventory The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold: Average Inventory Inventory Period = Annual Cost of Goods Sold / 365 The inventory period also can be written as: 365 Inventory Period = Inventory Turnover Other asset turnover ratios include fixed asset turnover and total asset turnover. Financial Leverage Ratios Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. The debt ratio is defined as total debt divided by total assets: Total Debt Debt Ratio = Total Assets The debt-to-equity ratio is total debt divided by total equity: Total Debt Debt-to-Equity Ratio = Total Equity Debt ratios depend on the classification of long-term leases and on the classification of some items as longterm debt or equity. The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows: EBIT Interest Coverage = Interest Charges where EBIT = Earnings Before Interest and Taxes Profitability Ratios Profitability ratios offer several different measures of the success of the firm at generating profits. The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows: Sales - Cost of Goods Sold Gross Profit Margin = Sales Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as: Net Income Return on Assets = Total Assets Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows: Net Income Return on Equity = Shareholder Equity Dividend Policy Ratios Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio. The dividend yield is defined as follows: Dividends Per Share Dividend Yield = Share Price

A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend payout ratio is helpful in this regard, and is defined as follows: Dividends Per Share Payout Ratio = Earnings Per Share Use and Limitations of Financial Ratios Attention should be given to the following issues when using financial ratios: A reference point is needed. To to be meaningful, most ratios must be compared to historical values of the same firm, the firm's forecasts, or ratios of similar firms. Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm's situation. Year-end values may not be representative. Certain account balances that are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available. Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values. What is Ratio Analysis? Ratio analysis is a type of analysis that helps you better understand and guide the financial affairs of your business. A ratio is a mathematical expression and is computed using information from the balance sheet and/or income statement. How You Can Use Ratio Analysis in Your Business? You can see how your business is doing by checking your most recent ratios against previous ratios on a regular basis. This will help you improve the quality of business management decisions and the performance of your business. You can also check your ratios against ratios of other firms in your industry. This will tell you if your business is performing better or worse than other business firms in the industry. You can find information on the ratios typical to your business in publications such as Dunn and Bradstreet's Industry Norms and Key Business Ratios. This reference is available in many public libraries and university libraries. Also, industry trade associations often furnish important financial data, such as figures of differently sized businesses in terms of sales, expenses, capital requirements and profit percentages. Ratio Analysis Formulas There are many ratios you can use to analyze and gauge the financial health of your business. This fact sheet will discuss four key financial performance areas worth analyzing: liquidity, profitability, solvency and efficiency. Liquidity measures how easily you can turn assets into cash. Three common measures of liquidity include working capital, the current ratio and the quick ratio. Working capital measures a company's cash flow position. The current ratio measures the degree to which current assets can be used to pay current debt obligations. The quick ratio measures the degree to which very liquid current assets can be converted to cash to meet current debt obligations. Generally, the larger the ratio, the more liquid the business. Working Capital = Total Current Assets Total Current Liabilities Current Ratio = Total Current Assets Total Current Liabilities Quick Ratio = (Total Current Assets Inventory) Total Current Liabilities Profitability measures the degree to which the business is profitable. Three common profitability ratios include return on investment, return on total assets, and return on sales. Return on investment measures the return on funds invested by the owners of the business. Return on total assets measures how efficiently profits are being generated from assets employed in the business. Return on sales or net profit margin is a measure of overall business success. Generally, the larger (more positive) the ratio, the more profitable the business. Return on Investment = Net Profit (Loss) Net Worth Return on Total Assets = Net Profit (Loss) Total Assets Return on Sales = Net Profit (Loss) Net Sales Solvency measures the degree to which the business relies on debt financing. Two common solvency ratios are the leverage ratio and the debt to assets ratio. The leverage ratio measures the degree to which the business uses borrowed versus owner's money in the business. The debt to assets ratio measures the degree to which total assets are being financed by creditors. Generally, the larger the ratio, the less solvent the business. Leverage Ratio = Total Liabilities Net Worth

Debt to Assets Ratio = Total Liabilities Total Assets Efficiency measures the degree to which the business is effectively utilizing its resources in generating sales and profits for the business. Two common efficiency ratios are the asset turnover ratio and the inventory turnover ratio. The asset turnover ratio measures the degree to which the total assets of the firm are being used to generate sales. The inventory turnover ratio measures how well the business's inventory is being managed. Generally, the larger the ratio, the more efficient the business. Asset Turnover Ratio = Net Sales Total Assets Inventory Turnover Ratio = Net Sales Average Inventory At Cost Summary Ratio analysis is an analytical tool that you can use to see how your business's financial affairs compare year to year and to other business firms in the same industry. The information and data gained from ratio analysis will help you make more informed business decisions and help keep your business economically viable.