By JAMES LEICHTER
How's business? Of course, that's a loaded question. Better questions are: are your co-workers working as efficiently as they should be? How does your company compare to other similar businesses? Could your company survive a "doomsday" scenario? Using financial ratio analysis, you can learn the answers to these questions and more.
Financial ratios are formed when two or more numbers are taken from a financial statement and combined in different ways. Typically, these numbers are taken from the income statement and balance sheet.
Financial ratios are primarily used to gauge the profitability, solvency, and efficiency of a business. Profitability ratios gauge how successfully the company is able to produce a profit. Solvency ratios measure the company's ability to meet financial obligations in a timely manner. Efficiency ratios measure how efficiently the company uses its assets (including people) in generating sales or profits.
Basic Terms
Before we go any further, let's define a few of common terms.
COGS (cost of goods sold): An income statement figure that represents the cost of equipment, materials, subcontractors, labor, and other direct expenses purchased for a specific job.
Expenses (also known as overhead): General and administrative expenses, not including depreciation and amortization.
Accounts receivable: Money owed by customers for goods and services you have provided them (unpaid invoices).
Accounts payable: Money owed to vendors for goods and services that they have provided you (unpaid bills).
Current assets: A balance sheet item which equals the sum of cash, accounts receivable, inventory, prepaid expenses, and other assets that could be easily converted to cash in less than one year.
Current liabilities: A balance sheet item which equals the sum of accounts payable, short term debt, notes payable, taxes payable, withholdings and other liabilities that must be satisfied within one year.
Working capital: Current assets less current liabilities.
Now let's take a look at some common ratios.
Profitability Ratios
Return on sales (net profit margin): This measures the profits before taxes on the year's sales. The higher this ratio, the better prepared your business is to handle pricing pressure brought on by low priced competitors.
The formula:
(Net Profit Before Taxes / Net Sales) x 100
Approximate industry average: 4%
Our recommendation: 10% or greater.
Return on assets (net profit to total assets): In our opinion, this is the key indicator of the company's profitability. It matches net profits after taxes with the assets used to earn those profits. A high percentage rate will tell you your company is well run, and has a healthy return on assets.
The formula:
(Net Profit Before Taxes / Total Assets) x 100
Approximate industry average: 6% to 8%
Our recommendation: 15% or greater.
Solvency Ratios
Current ratio: This ratio expresses the working capital relationship of current assets to cover current liabilities. Generally, a ratio of 2 to 1 is considered a sign of good financial condition. However, much depends on the standards of the specific industry you are reviewing. If a company's inventory is slow in selling, a stronger current ratio is required.
The formula:
Current Assets / Current Liabilities
Approximate industry average: 1.5 to 2.1
Our recommendation: 2.0 or greater.
Quick ratio: Sometimes called the "acid test" or "liquid" ratio, this ratio is a favorite among lenders. It measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash.
The formula:
(Cash + Accounts Receivable) / Current Liabilities
Approximate industry average: 1.2 to 1.6
Our recommendation: 1.35 or greater.
Total liabilities to total assets: This measures a company's ability to absorb asset reductions arising from operating loses without jeopardizing its ability to satisfy creditors and other financial obligations.
The formula:
Total Liabilities / Total Assets
Approximate industry average: 1.15
Our recommendation: 1.25 or greater.
Working capital to total assets: This ratio indicates what percent of assets are in the form of working capital. This ratio is important because if liabilities must be paid quickly, only working capital may be converted to cash relatively quickly.
The formula:
Total Assets / Working Capital
Approximate industry average: 0.10 to 0.12
Our recommendation: 0.25 or greater.
Doomsday ratio (cash to current liabilities): The ratio gets its name because it measures a company's ability to handle the absolute worse case scenario; liabilities must be satisfied immediately. This is the most demanding of all solvency ratios. The higher this ratio, the better prepared a business is to handle downturns brought on by adverse conditions.
We generally recommend a ratio of 1 — in other words, you have $1 in cash to pay off $1 of liabilities.
The formula:
Cash / Current Liabilities
Approximate industry average: 0.6 to 0.9
Our recommendation: 1.00
Efficiency Ratios
Average age of accounts receivable (also known as collection period): This is helpful in analyzing the quality or "collectability" of accounts receivable. Accounts receivables that are 10 or 15 days over your standard terms should be a concern, although that varies depending on the credit terms you are offering to customers.
The formula:
(Average Accounts Receivable / Sales) x 365 Days.
Approximate industry average: 47
Our recommendation: 40 or less.
Sales to total labor: This indicates how much of your total sales revenue (income) is consumed by all payroll- and labor-related expenses. The lower the number the better, because it suggests that you are efficiently using employees to create sales and manage them.
The formula:
(Labor COGS + Labor Expenses) / Sales)) x 100
Approximate industry average: 35%
Our recommendation: 30% or less.