How to Analyze Your Business Using Financial Ratios

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Digital Library > Acquiring and Managing Finances > Ratio analysis"How to Analyze Your Business Using Financial Ratios"

Using a sample income statement and balance sheet, this guide shows you how to convert the raw data on financial statements into information that will help you manage your business_

WHAT TO EXPECT

Many small and mid-sized companies are run by entrepreneurs who are highly skilled in some key aspect of their business—perhaps technology, marketing or sales—but are less savvy in financial matters. The goal of this document is to help you become familiar with some of the most powerful and widely-used tools for analyzing the financial health of your company.

Some of the names—"common size ratios" and "liquidity ratios," for example—may be unfamiliar. But nothing in the following pages is actually very difficult to calculate or very complicated to use. And the payoff to you can be enormous. The goal of this document is to provide you with some handy ways to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry. Once you get comfortable with these tools you will be able to turn the raw numbers in your company's financial statements into information that will help you to better manage your business.

WHAT YOU SHOULD KNOW BEFORE GETTING STARTED [top]

For most of us, accounting is not the easiest thing in the world to understand, and often the terminology used by accountants is part of the problem. "Financial ratio analysis" sounds pretty complicated. In fact, it is not. Think of it as "batting averages for business."

If you want to compare the ability of two Major League home-run sluggers, you are likely to look at their batting averages. If one is hitting .357 and the other's average is .244, you immediately know which is doing better, even if you don't know precisely how a batting average is calculated. In fact, this classic sports statistic is a ratio: it's the number of hits made by the batter, divided by the number of times the player was at bat. (For baseball purists, those are "official at-bats," which is total appearances at the plate minus walks, sacrifice plays and any times the player was hit by a pitch.)

You can think of the batting average as a measure of a baseball player's productivity; it is the ratio of hits made to the total opportunities to make a hit. Financial ratios measure your company's productivity. There are many ratios you can use, but they all measure how good a job your company is doing in using its assets, generating profits from each dollar of sales, turning over inventory, or whatever aspect of your company's operation that you are evaluating.

Financial Ratio Analysis

The use of financial ratios is a time-tested method of analyzing a business. Wall Street investment firms, bank loan officers and knowledgeable business owners all use financial ratio analysis to learn more about a company's current financial health as well as its potential.

Although it may be somewhat unfamiliar to you, financial ratio analysis is neither sophisticated nor complicated. It is nothing more than simple comparisons between specific pieces of information pulled from your company's balance sheet and income statement.

A ratio, you will remember from grammar school, is the relationship between two numbers. As your math teacher might have put it, it is "the relative size of two quantities, expressed as the quotient of one divided by the other." If you are thinking about buying shares of a publicly-traded company, you might look at its price-earnings ratio. If the stock is selling for $60 per share, and the company's earnings are $2 per share, the ratio of price ($60) to earnings ($2) is 30 to 1. In common usage, we would say the "P/E ratio is 30."

Financial ratio analysis can be used in two different but equally useful ways. You can use them to examine the current performance of your company in comparison to past periods of time, from the prior quarter to years ago. Frequently this can help you identify problems that need fixing. Even better, it can direct your attention to potential problems that can be avoided. In addition, you can use these ratios to compare the performance of your company against that of your competitors or other members of your industry.

Remember that the ratios you will be calculating are intended simply to show broad trends and thus to help you with your decision-making. They need only be accurate enough to be useful to you. Don't get bogged down calculating ratios to more than one or two decimal places. Any change that is measured in hundredths of a percent will almost certainly have no meaning. Make sure your math is correct, but don't agonize over it.

A ratio can be expressed in several ways. A ratio of two-to-one can be shown as:

2:1          2-to-1          2/1

In these pages, when we present a ratio in the text it will be written out, using the word "to." If the ratio is in a formula, the slash sign (/) will be used to indicate division.

Types of Ratios

As you use this guide you will become familiar with the following types of ratios:

  • Common size ratios
  • Liquidity ratios
  • Efficiency ratios
  • Solvency ratios

COMMON SIZE RATIOS [top]

One of the most useful ways for the owner of a small business to look at the company's financial statements is by using "common size" ratios. Common size ratios can be developed from both balance sheet and income statement items. The phrase "common size ratio" may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total.

For example, each of the items on the income statement would be calculated as a percentage of total sales. (Divide each line item by total sales, then multiply each one by 100 to turn it into a percentage.) Similarly, items on the balance sheet would be calculated as percentages of total assets (or total liabilities plus owner's equity.)

This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons. If you want to evaluate your cash position compared to the cash position of one of your key competitors, you need more information than what you have, say, $12,000 and he or she has $22,000. That's a lot less informative than knowing that your company's cash is equal to 7% of total assets, while your competitor's cash is 9% of their assets. Common size ratios make comparisons more meaningful; they provide a context for your data.

Common Size Ratios from the Balance Sheet

To calculate common size ratios from your balance sheet, simply compute every asset category as a percentage of total assets, and every liability account as a percentage of total liabilities plus owners' equity.

Here is what a common size balance sheet looks like for the mythical Doobie Company:

ABC Company
Common Size Balance Sheet
For the year ending December 31, 200x

Assets $$ % Current Assets          Cash 12,000 6.6%      Marketable Securities 10,000 5.5% Accounts Receivable (net of uncollectible accounts) 17,000 9.4%      Inventory 22,000 12.2%      Prepaid Expense 4,000 2.2%      Total Current Assets 65,000 35.9% Fixed Assets          Building and Equipment 105,000 58.3%      Less Depreciation 30,000 16.6%      Net Buildings and Equipment 75,000 41.6%      Land 40,000 22.2%      Total Fixed Assets 115,000 63.8% Total Assets 180,000 100.0% Liabilities     Current Liabilities          Wages Payable 3,000 1.6%      Accounts Payable 25,000 13.8%      Taxes Payable 12,000 6.6%      Total Current Liabilities 40,000 22.2% Long-Term Liabilities          Mortgage Payable 70,000 38.8%      Note Payable 15,000 8.3%      Deferred Taxes 15,000 8.3%      Total Long-Term Liabilities 100,000 55.5%      Total Liabilities 140,000 77.7%      Owner's Equity 40,000 22.2% Total Liabilities and Owner's Equity 180,000 100.0%

In the example for Doobie Company, cash is shown as being 6.6% of total assets. This percentage is the result of the following calculation:

12,000/180,000 x 100

(Multiplying by 100 converts the ratio into a percentage.)

Common size ratios translate data from the balance sheet, such as the fact that there is $12,000 in cash, into the information that 6.6% of Doobie Company's total assets are in cash. Additional information can be developed by adding relevant percentages together, such as the realization that 11.7% (6.6% + 5.1%) of Doobie's total assets are in cash and marketable securities.

Common size ratios are a simple but powerful way to learn more about your business. This type of information should be computed and analyzed regularly.

As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities. Receivables should not be tying up an undue amount of company assets. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action. This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers.

As this example illustrates, the point of doing financial ratio analysis is not to collect statistics about your company, but to use those numbers to spot the trends that are affecting your company. Ask yourself why key ratios are up or down compared to prior periods or to your competitors. The answers to those questions can make an important contribution to your decision-making about the future of your company.

Current ratio analysis is also a very helpful way for you to evaluate how your company uses its cash.

Obviously it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you. The balance sheet for the Doobie Company shows that the company can meet current liabilities. The line items of "total current liabilities," $40,000, is substantially lower than "total current assets," $65,000.

But you may wonder, "How do I know if my current ratio is out of line for my type of business?" You can answer this question (and similar questions about any other ratio) by comparing your company with others. You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios. (See the Resources section at the end of this document.)

Because financial ratio comparisons are so important for bank loan officers who make loans to businesses, RMA (formerly a bankers' trade association, Robert Morris Associates) has for many years published a volume called "Annual Statement Studies." These contain ratios for more than 300 industries, broken down by asset size and sales size. RMA's "Annual Statement Studies" are available in most public and academic libraries, or you may ask your banker to obtain the information you need.

Another source of information is "Industry Norms and Key Business Ratios," published by Dun and Bradstreet. It is compiled from D&B's vast databases of information on businesses. It lists financial ratios for hundreds of industries, and is available in academic and public libraries that serve business communities.

These and similar publications will give you an industry standard or "benchmark" you can use to compare your firm to others. The ratios described in this guide, and many others, are included in these publications. While period-to-period comparisons based on your own company's data are helpful, comparing your company's performance with other similar businesses can be even more informative.

Compute common size ratios using your company's balance sheet.

Common Size Ratios from the Income Statement

To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales. This converts the income statement into a powerful analytical tool.

Here is what a common size income statement looks like for the fictional Doobie Company:

  $$ % Sales $ 200,000 100% Cost of goods sold 130,000 65% Gross Profit 70,000 35% Operating expenses     Selling expenses 22,000 11% General e xpenses 10,000 5% Administrative expenses 4,000 2% Total operating expenses 36,000 18% Operating income 34,000 17% Other income 2,500 1% Interest expense 500 0% Income before taxes 36,000 18% Income taxes 1,800 1% Net profit 34,200 17%

Common size ratios allow you to make knowledgeable comparisons with past financial statements for your own company and to assess trends—both positive and negative—in your financial statements.

The gross profit margin and the net profit margin ratios are two common size ratios to which small business owners should pay particular attention. On a common size income statement, these margins appear as the line items "gross profit" and "net profit." For the Doobie Company, the common size ratios show that the gross profit margin is 35% of sales. This is computed by dividing gross profit by sales (and multiplying by 100 to create a percentage.)

$70,000/200,000 x 100 = 35%

Even small changes of 1% or 2% in the gross profit margin can affect a business severely. After all, if your profit margin drops from 5% of sales to 4%, that means your profits have declined by 20%.

Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. For example, if profit margins have declined unexpectedly, you probably will want to closely examine all expenses—again, using the common size ratios for expense line items to help you spot significant changes.

Compute common size ratios from your income statement.

Look at the gross profit and net profit margins as a percentage of sales. Compare these percentages with the same items from your income statement of a year ago. Are any fluctuations favorable or not? Do you know why they changed?

LIQUIDITY RATIOS [top]

Liquidity ratios measure your company's ability to cover its expenses. The two most common liquidity ratios are the current ratio and the quick ratio. Both are based on balance sheet items.

Current Ratio

The current ratio is a reflection of financial strength. It is the number of times a company's current assets exceed its current liabilities, which is an indication of the solvency of that business.

Here is the formula to compute the current ratio.

Current Ratio = Total current assets/Total current liabilities

Using the earlier balance sheet data for the mythical Doobie Company, we can compute the company's current ratio.

Doobie Company Current Ratio:

65,000/40,000 = 1.6

This tells the owners of the Doobie Company that current liabilities are covered by current assets 1.6 times. The current ratio answers the question, "Does the business have enough current assets to meet the payment schedule of current liabilities, with a margin of safety?"

A common rule of thumb is that a "good" current ratio is 2 to 1. Of course, the adequacy of a current ratio will depend on the nature of the business and the character of the current assets and current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. That's why a safety margin is needed.

A current ratio can be improved by increasing current assets or by decreasing current liabilities. Steps to accomplish an improvement include:

  • Paying down debt.
  • Acquiring a long-term loan (payable in more than 1 year's time).
  • Selling a fixed asset.
  • Putting profits back into the business.

A high current ratio may mean that cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment.

Quick Ratio

The Quick Ratio is also called the "acid test" ratio. That's because the quick ratio looks only at a company's most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even if adverse conditions occur.

Here is the formula for the quick ratio:

Quick Ratio = (Current Assets − Inventory)/Current Liabilities

Assets considered to be "quick" assets include cash, stocks and bonds, and accounts receivable (in other words, all of the current assets on the balance sheet except inventory.)

Using the balance sheet data for the Doobie Company, we can compute the quick ratio for the company.

Quick ratio for the Doobie Company:

(65,000 − 22,000)/40,000 = 1.07

In general, quick ratios between 0.5 and 1 are considered satisfactory—as long as the collection of receivables is not expected to slow. So the Doobie Company seems to have an adequate quick ratio.

Compute a current ratio and a quick ratio using your company's balance sheet data.

OPERATING RATIOS [top]

There are many types of ratios that you can use to measure the efficiency of your company's operations. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company.

The four ratios we will look at are:

  • Inventory Turnover Ratio
  • Sales to Receivables Ratio
  • Days' Receivables Ratio
  • Return on Assets

Inventory Turnover

The inventory turnover ratio measures the number of times inventory "turned over" or was converted into sales during a time period. It is also known as the cost-of-sales to inventory ratio. It is a good indication of purchasing and production efficiency.

The data used to calculate this ratio come from both the company's income statement and balance sheet. Here is the formula:

Inventory Ratio = Cost of Goods Sold/Inventory

Using the financial statements for the Doobie Company, we can compute the following inventory turnover ratio for the company:

$130,000/22,000 = 5.91

In general, the higher a cost of sales to inventory ratio, the better. A high ratio shows that inventory is turning over quickly and that little unused inventory is being stored.

Sales-to-Receivables Ratio

The sales-to-receivables ratio measures the number of times accounts receivables turned over during the period. The higher the turnover of receivables, the shorter the time between making sales and collecting cash. The ratio is based on NET sales and NET receivables. (A reminder: net sales equals sales less any allowances for returns or discounts. Net receivables equals accounts receivable less any adjustments for bad debts.)

This ratio also uses information from both the balance sheet and the income statement. It is calculated as follows:

Sales-to-Receivables Ratio = Net Sales/Net Receivables

Using the financial statements for the Doobie Company (and assuming that the Sales reported on their income statement is net Sales), we can compute the following sales- to-receivables ratio for the company:

Doobie Company Sales-to-Receivables Ratio:

200,000/17,000 = 11.76

This means that receivables turned over nearly 12 times during the year. This is a ratio that you will definitely want to compare to industry standards. Keep in mind that its significance depends on the amount of cash sales a company has. For a company without many cash sales, it may not be important. Also, it is a measure at only one point in time and does not take into account seasonal fluctuations.

Days' Receivables Ratio

The days' receivables ratio measures how long accounts receivable are outstanding. Business owners will want as low a days' receivables ratio as possible. After all, you want to use your cash to build your company, not to finance your customers. Also, the likelihood of nonpayment typically increases as time passes.

It is computed using the sales/receivables ratio. Here is the formula:

Days' Receivables Ratio = 365/Sales Receivables Ratio

The "365" in the formula is simply the number of days in the year. The sales receivable ratio is taken from the calculation we did just a few paragraphs earlier.

Using the financial statements for the Doobie Company, we can compute the following day's receivables ratio for the company.

Doobie Company Days' Receivables Ratio

365/11.76 = 31

This means that receivables are outstanding an average of 31 days. Again, the real meaning of the number will only be clear if you compare your ratios to others in the industry.

Return on Assets

The return on assets ratio measures the relationship between profits your company generated and assets that were used to generate those profits. Return on assets is one of the most common ratios for business comparisons. It tells business owners whether they are earning a worthwhile return from the wealth tied up in their companies. In addition, a low ratio in comparison to other companies may indicate that your competitors have found ways to operate more efficiently. Publicly held companies commonly report return on assets to shareholders; it tells them how well the company is using its assets to produce income.

It is computed as follows:

Return on Assets = Net Income Before Taxes/Total Assets X 100

(Multiplying by 100 turns the ratio into a percentage.)

Using the balance sheet and income statement for the Doobie Company, we can compute the return on assets ratio for the company:

Doobie Company Return on Assets:

$36,000/180,000 x 100 = 20%

This is a ratio that you will certainly want to compare with other firms in your industry.

SOLVENCY RATIOS [top]

Solvency ratios measure the stability of a company and its ability to repay debt. These ratios are of particular interest to bank loan officers. They should be of interest to you, too, since solvency ratios give a strong indication of the financial health and viability of your business.

We will look at the following solvency ratios:

  • Debt-to-worth ratio
  • Working capital
  • Net sales to working capital
  • Z-Score

Debt-to-Worth Ratio

The debt-to-worth ratio (or leverage ratio) is a measure of how dependent a company is on debt financing as compared to owner's equity. It shows how much of a business is owned and how much is owed.

The debt-to-worth ratio is computed as follows:

Debt-to-Worth Ratio = Total Liabilities/Net Worth

(A reminder: Net Worth = Total Assets Minus Total Liabilities.)

Using balance sheet data for the Doobie Company, we can compute the debt-to-worth ratio for the company.

Doobie Company debt-to-worth ratio:

$140,000/40,000 = 3.5

If the debt-to-worth ratio is greater than 1, the capital provided by lenders exceeds the capital provided by owners. Bank loan officers will generally consider a company with a high debt-to-worth ratio to be a greater risk. Debt-to-worth ratios will vary with the type of business and the risk attitude of management.

Working Capital

Working capital is a measure of cash flow, and not a real ratio. It represents the amount of capital invested in resources that are subject to relatively rapid turnover (such as cash, accounts receivable and inventories) less the amount provided by short-term creditors. Working capital should always be a positive number. Lenders use it to evaluate a company's ability to weather hard times. Loan agreements often specify that the borrower must maintain a specified level of working capital.

Working capital is computed as follows:

Working Capital = Total Current Assets − Total Current Liabilities

Using the balance sheet data for the Doobie Company, we can compute the working capital amount for the company.

Doobie Company working capital:

$65,000 − 40,000 = $25,000

Doobie Company has $25,000 in working capital

Net Sales to Working Capital

The relationship between net sales and working capital is a measurement of the efficiency in the way working capital is being used by the business. It shows how working capital is supporting sales.

It is computed as follows:

Net Sales to Working Capital Ratio = Net Sales/Net Working Capital

Using balance sheet data for the Doobie Company and the working capital amount computed in the previous calculation, we compute the net sales to working capital as follows:

Doobie Company Net Sales to Working Capital Ratio

$200,000/25,000 = 8

Again, this is a ratio that must be compared to others in your industry to be meaningful. In general, a low ratio may indicate an inefficient use of working capital; that is, you could be doing more with your resources, such as investing in equipment. A high ratio can be dangerous, since a drop in sales which causes a serious cash shortage could leave your company vulnerable to creditors.

Z-SCORE [top]

The Z-Score is at the end of our list neither because it is the least important, nor because it's at the end of the alphabet. It's here because it's a bit more complicated to calculate. In return for doing a little more arithmetic, however, you get a number—a Z-Score—which most experts regard as a very accurate guide to your company's financial solvency. In blunt terms, a Z-Score of 1.81 or below means you are headed for bankruptcy. One of 2.99 means your company is sound.

The Z-Score was developed by Edward I. Altman, a professor at the Leonard N. Stern School of Business at New York University. Dr. Altman researched dozens of companies that had gone bankrupt, and others that were doing well. He eventually focused on five key balance sheet ratios. He assigned a weight to each of the five, multiplying each ratio by a number he derived from his research to indicate its relative importance. The sum of the weighted ratios is the Z-Score.

Calculating The Z-Score

Ratio

Formula

Weighting Factor

Weighted Ratio

Return on
Total Assets

Earnings Before
Interest and Taxes /
Total Assets

x 3.3  

Sales to
Total Assets

Net Sales /
Total Assets

x 0.999  

Eq uity to Debt

Market Value of Equity / Total Liabilities

x 0.6  

Working Capital
to Total Assets

Working Capital /
Total Assets

x 1.2  

Retained Earnings
to Total Assets

Retained Earnings /
Total Assets

x 1.4   Total of all Weighted Ratios = Z-Score:  

Like many other ratios, the Z-Score can be used both to see how your company is doing on its own, and how it compares to others in your industry.

For a worksheet on calculating your Z-Score. Click below:

http://www.scotlandgroup.com/zscore.htm

Calculate the debt to worth ratio, working capital, and net sales to working capital ratio for your company. How do your ratios compare to others in your industry?

CHECKLIST [top]

This document has presented information on common size ratios for both the income statement and the balance sheet, plus several additional financial ratios you can use to gain a better understanding of the financial health of your business.

The ratios you will use most frequently are common size ratios from the income statement, the current ratio, the quick ratio and return on assets. Your specific type of business may require you to use some or all of the other ratios as well.

Financial ratio analysis is one way to turn financial statements, with their long columns of numbers, into powerful business tools. Financial ratio analysis offers a simple solution to numbers overload.

Common Size Ratios

___ When computing common size ratios for your company's balance sheet, were percentages for asset categories based on total assets? Were liability percentages based on total liabilities plus owners' equity?

___ Have you examined at least one source of comparative financial ratios?

Liquidity Ratios

___ What does the current ratio you computed for your business tell you about your company's ability to meet current liabilities?

___ Is your quick ratio between 0.5 and 1? If not, is there an explanation that is satisfactory to you?

Operating Ratios

___ When computing the sales-to-receivables ratio, did you remember to use NET sales and NET receivables?

Solvency Ratios

___ Does the net sales-to-working capital ratio that you computed make sense for your business? Are adjustments necessary?

Z-Score

___ Where is your company's Z-Score? If it is low, or the trend is down for recent years, do you know what changes you need to make?

RESOURCES [top]

Sources of Information on Profitability Analysis

Budgeting and Finance (First Books for Business) by Peter Engel. (McGraw-Hill, 1996).

Credit Process: A Guide for Small Business Owners by Tracy L. Penwell. (Federal Reserve Bank of New York, 1994).

Fundamentals of Financial Management, 11th ed. by James C. Van Horne and John Martin Wachowicz. (Prentice Hall, 2001).

Handbook of Financial Analysis for Corporate Managers, Revised ed. by Vincent Muro. (AMACOM, 1998).

How to Read and Interpret Financial Statements. (American Management Association, 1992).

Sources of Information on Financial Ratios

RMA Annual Statement Studies, Risk Management Association. Data for 325 lines of business, sorted by asset size and by sales volume to allow comparisons to companies of similar size in the same industry. The "common size" (percentage of total assets or sales) is provided for each balance sheet and income statement item.

Almanac of Business and Industrial Financial Ratios, annual, by Leo Troy. (Prentice-Hall, Inc.). Information for 150 industries on 22 financial categories. Data is usually three years prior to the publication date.

Financial Studies of the Small Business by Karen Goodman. Financial Research Associates. Focusing on business with capitalizations under $1 million, providing financial ratios and other information.

Industriscope: Comprehensive Data for Industry Analysis. Media General Financial Services. Compare company-to-company, company-to-industry & industry-to-industry; 215 industry groups; over 9,000 companies grouped within their industry; over 40 key items listed on each company & industry; price, price change & relative price data; shareholdings data; revenue, earnings & dividend data; ratio analysis; historical archives available back to May 1973.

Kauffman Business EKG, Kauffman Center for Entrepreneurial Leadership. A fill-in-the-blanks calculator for several income and sales ratios.


Writer: Alex Auerbach

All rights reserved. The text of this publication, or any part thereof, may not be reproduced in any manner whatsoever without written permission from the publisher.

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