Financial Statement Analysis Using Ratios

Before investing in any company, investors typically focus on uncovering items that would impact their investing decisions. Knowing that investors use the balance sheet and income statement to make investment decisions, companies usually engage in unusual or aggressive accounting practices inorder to flatter their reported figures. Using various financial ratios, investors are able to evaluate the operational health of the business. We here by summarize the most important financial ratios that can assist an investor in evaluating the financial health of a company before investing.

Current Ratio

Definition:

The ratio between all current assets and all current liabilities; another way of expressing liquidity.

Formula:

   Current Assets divided by Current Liabilities

Analysis:

– 1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible. – One problem with the current ratio is that it ignores timing of cash received and paid out. For example, if all the bills are due this week, and inventory is the only current asset, but won’t be sold until the end of the month, the current ratio tells very little about the company’s ability to survive.

Quick Ratio

Definition:

The ratio between all assets quickly convertible into cash and all current liabilities. Specifically excludes inventory.

Formula:

(Cash + Accounts Receivable)     divided by   Current Liabilities

Analysis:

– Indicates the extent to which you could pay current liabilities without relying on the sale of inventory how quickly you can pay your bills. Generally, a ratio of 1:1 is good and indicates you don’t have to rely on the sale of inventory to pay the bills. – Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments.

Cash Ratio

Definition:

The ratio is the most conservative. It excludes all current assets except the most liquid: cash and cash equivalent.

Formula:

  (Cash + Marketable Securities) divided by Current Liabilities

Analysis:

– It is an indicator of the firm’s ability to pay off its current liabilities if some immediate payments were demanded. The higher the better, but one should take into consideration not to leave a lot of idle cash on hand, because the opportunity cost of not investing these amounts becomes high. 

Debt to Equity

Definition:

Shows the ratio between capital invested by the owners and the funds provided by lenders.

Formula:

Debt  divided by  Equity

Analysis:

– Comparison of how much of the business was financed through debt and how much was financed through equity. For this calculation it is common practice to include loans from owners in equity rather than in debt. – The higher the ratio, the greater the risk to a present or future creditor.  – Look for a debt to equity ratio in the range of 1:1 to 4:1 – Most lenders have credit guidelines and limits for the debt to equity ratio (2:1 is a commonly used limit for small business loans). – Too much debt can put your business at risk… but too little debt may mean you are not realizing the full potential of your business — and may actually hurt your overall profitability. This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate). If you think that you might be in this situation, talk to your accountant or financial advisor.

Debt coverage ratio

Definition:

Indicates how well your cash flow covers debt and the capacity of the business to take on additional debt.

Formula:

(Net Profit + Non-cash expenses)       divided by      Debt

Analysis:

– Shows how much of your cash profits are available to repay debt. – Lenders look at this ratio to determine if there is adequate cash to make loan payments. – Most lenders also have limits for the debt coverage ratio.

Sales Growth

Definition:

Percentage increase (or decrease) in sales between two time periods.

Formula:

(Current Year’s sales – Last Year’s sales)         divided by  Last Year’s sales

Note: substitute sales for a month or quarter for a shorter term trend.

Analysis:

– Look for a steady increase in sales. – If overall costs and inflation are on the rise, then you should watch for a related increase in your sales… if not, then this is an indicator that your Prices are not keeping up with your costs.

COGS to Sales

Definition:

Percentage of sales used to pay for expenses which vary directly with sales.

Formula:

Cost of Goods Sold  divided by  Sales

Analysis:

– Look for a stable ratio as an indicator that the company is controlling its gross margins.

Gross Profit Margin

Definition:

Indicator of how much profit is earned on your products without consideration of selling and administration costs.

Formula:

Gross Profit divided by Total Sales where Gross Profit = Sales less Cost of Goods Sold

Analysis:

– Compare to other businesses in the same industry to see if your business is operating as profitably as it should be. – Look at the trend from month to month. Is it staying the same? Improving? Deteriorating? – Is there enough gross profit in the business to cover your operating costs? – Is there a positive gross margin on all your products?

SG&A to Sales

Definition:

Percentage of selling, general and administrative costs to sales.

Formula:

Selling, General & Administrative Expenses divided by Sales

Analysis:

– Look for a steady or decreasing percentage indicating that the company is controlling its overhead expenses.

Net Profit Margin

Definition:

Shows how much profit comes from every dollar of sales.

Formula:

Net Profit divided by Total Sales

Analysis:

– Compare to other businesses in the same industry to see if your business is operating as profitably as it should be. – Look at the trend from month to month. Is it staying the same? Improving? Deteriorating? – Are you generating enough sales to leave an acceptable profit? – Trend from month to month can show how well you are managing your operating or overhead costs.

Return on Equity

Definition:

Determines the rate of return on your investment in the business. As an owner or shareholder this is one of the most important ratios as it shows the hard fact about the business — are you making enough of a profit to compensate you for the risk of being in business?

Formula:

Net Profit divided by Equity

Analysis:

– Compare the return on equity to other investment alternatives, such as a savings account, stock or bond. – Compare your ratio to other businesses in the same or similar industry.

Return on Assets

Definition:

Considered a measure of how effectively assets are used to generate a return. (This ratio is not very useful for most businesses.)

Formula:

  Net Profit  divided by Total Assets

Analysis:

– ROA shows the amount of income for every dollar tied up in assets. – Year to year trends may be an indicator … but watch out for changes in the total asset figure as you depreciate your assets (a decrease or increase in the denominator can effect the ratio and doesn’t necessarily mean the business is improving or declining.

Net Sales to Tangible Net Worth

Definition:

This ratio indicates whether your investment in the business is adequately proportionate to your sales volume.

Formula:

  Net Sales  divided by (Owner’s Equity – Intangible Assets)

Analysis:

– It may also uncover potential credit or management problems, usually called “overtrading” and “undertrading.”

Overtrading, or excessive sales volume transacted on a thin margin of investment, presents a potential problem with creditors. Overtrading can come from considerable management skill, but outside creditors must furnish more funds to carry on daily operations.

Undertrading is usually caused by management’s poor use of investment money and their general lack of ingenuity, skill or aggressiveness

Days in Receivables

Definition:

This calculation shows the average number of days it takes to collect your accounts receivable (number of days of sales in receivables).

Formula:

Average Accounts Receivable divided by  Sales X 360 days

Analysis:

– Look for trends that indicate a change in your customers’ payment habits. – Compare the calculated days in receivables to your stated terms. – Compare to industry standards. – Review an Aging of Receivables and be familiar with your customers payment habits and watch for any changes that might indicate a problem.

 Accounts Receivable Turnover

Definition:

Number of times that trade receivables turnover during the year.

Formula:

Net Sales divided by Average Accounts Receivable

Analysis:

– The higher the turnover, the shorter the time between sales and collecting cash. – Compare to industry standards.

 Days in Inventory

Definition:

This calculation shows the average number of days it will take to sell your inventory (number of days sales @ cost in inventory).

Formula:

Average Inventory divided by Cost of Goods Sold   X   360 days

Analysis:

– Look for trends that indicate a change in your inventory levels. – Compare the calculated days in inventory to your inventory cycle. – Compare to industry standards.

 Inventory Turnover

Definition:

Number of times that you turn over (or sell) inventory during the year.

Formula:

Cost of Goods Sold divided by Average Inventory

Analysis:

– Generally, a high inventory turnover is an indicator of good inventory management. – But a high ratio can also mean there is a shortage of inventory. – A low turnover may indicate overstocking, or obsolete inventory. – Compare to industry standards.

 Inventory to Net Working Capital

Definition:

 This ratio tells how much of a company’s funds are tied up in inventory. It is preferable to run your business with as little inventory as possible on hand, while not affecting potential sales opportunities.

Formula:

Inventory divided by (Current Asset – Current Liability)

Analysis:

If this number is high compared to the average for your industry, it could mean your business is carrying too much inventory.

Sales to Total Assets

Definition:

Indicates how efficiently your business generates sales on each dollar of assets.

Formula:

     Sales divided by Total Assets

Analysis:

 A volume indicator that can be used to measure efficiency of your business from year to year.

Days in Accounts Payable

Definition:

This calculation shows the average length of time your trade payables are outstanding before they are paid. (number of days sales @ cost in payables).

Formula:

Average Accounts Payable divided by COGS X  360 days

Analysis:

– Look for trends that indicate a change in your payment habits. – Compare the calculated days in payables to the terms offered by your suppliers and to industry standards. – Review an Aging of Payables and be familiar with the terms offered by your suppliers.

 Accounts Payable Turnover

Definition:

The number of times trade payables turnover during the year.

Formula:

COGS divided by Average Accounts Payable

Analysis:

– The higher the turnover, the shorter the time between purchase and payment. – A low turnover may indicate that there is a shortage of cash to pay your bills or some other reason for a delay in payment.

 Management Rate Of Return  

Definition:

This efficiency ratio compares operating income to operating assets, which are defined as the sum of tangible fixed assets and net working capital.

Formula:

Operating Fixed Assets + Net Working Capital

Analysis:

– The higher the return, the more you are making efficient use of your assets

-This rate, which you may calculate for your entire company or for each of its divisions or operations. The percentage should be compared with a target rate of return that you have set for the business.

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