WORKING WITH COMMON FINANCIAL STATEMENT RATIOS

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1 WORKING WITH COMMON FINANCIAL STATEMENT RATIOS I. YOUR LIFE GOALS 1

2 WORKING WITH COMMON FINANCIAL STATEMENT RATIOS Financial ratios are often categorized based on the types of information they provide. The most common categories are liquidity ratios, coverage ratios, leverage ratios and operating ratios. If you are unsure of any of the terms in the ratio calculations, please refer back to the previous section, Bookkeeping Basics Understanding the Basic Terminology. Liquidity Ratios Liquidity ratios measure the quality and adequacy of current assets to meet current liabilities. They help assess how well the company can convert its assets to cash and its ability to meet short term obligations. These ratios are often used by potential creditors to assess the company s short - term repayment capabilities. These ratios could help you assess: The company s ability to repay short-term debts; The company s ability to generate enough cash in the short-term to cover debts; The appropriateness of inventory levels; The efficiency of cash management of collections and trade payables. The most common liquidity ratios include: Current Ratio (Working Capital Ratio) = Total Current Assets Total Current Liabilities This ratio can indicate a company s ability to repay its debts over the next 12 months. The higher the ratio, the stronger the company s capabilities may be, subject to the composition and quality of the assets. For example, a high ratio may be a sign of excessive inventories or receivables. It may also indicate that the company has high levels of cash available. A low ratio may indicate that the company is improperly using current assets to finance the purchase of fixed assets. Quick Ratio (Acid Test) = Cash, Cash Equivalents and Trade Receivables (net) Total Current Liabilities This ratio is more stringent and considered more reliable than the current ratio in assessing a company s ability to repay its short-term obligations under the worst possible conditions. The formula limits the definition of assets to only those that can be quickly converted to cash at close to their book values. Assets such as inventory are generally excluded as they may be difficult to liquidate. 2

3 While a high ratio could generally be positive, it could also indicate excessive receivables and possible receivable aging issues. A low ratio could be a sign of a company s inability to pay off current liabilities. It may point to having too much inventory on hand or having aged or obsolete inventory. A ratio of less than 1:1 implies that inventories or other less certain assets may be required in order to pay off short-term debts. Receivable Turnover = Net Sales Average Trade Receivables (net) This ratio measures the number of times that receivables are collected during the year: the higher the number, the shorter the time between sale and collection. (To calculate your net average receivables, take the average of your collectible receivables from the beginning and end of the year). A high ratio is usually a good sign of a company s ability to generate cash flow as it shows that it can quickly collect its receivables. A low ratio could indicate poor billing and collections processes and possibly aged receivables. Days Receivables = 365 Receivable Turnover Ratio This formula converts the Receivable Turnover ratio into the average number of days that receivables are outstanding. This ratio is often used to help identify possible problem accounts. On an overall basis, it can help assess the effectiveness of the collections department, subject to the consistency of the client base and terms granted. A high result could indicate poor billing and collections processes and possibly aged receivables. A low result could be a good sign of a company s ability to generate cash flow as it shows that it can quickly collect its receivables. 3

4 Inventory Turnover = Cost of sales Average Inventory This formula measures the number of times inventory is turned during the year. To calculate average inventory, take the average of your inventory from the beginning and end of the year. A low turnover rate may point to problems such as inventory obsolescence or overstocking. However, lower rate may also point to an inventory buildup in anticipation of expected sales increases. A high turnover rate may be a positive indication of a company s ability to rapidly sell inventory. Conversely, it could point to possible inventory shortages. Days Inventory = 365 Inventory Turnover Ratio This formula converts the Inventory Turnover ratio into the average number of days that items are in inventory. A high result could point to inventory obsolescence or over-stocking. A low result may be a positive indication of a company s ability to rapidly sell inventory. Conversely, it could point to possible inventory shortages. Payables Turnover = Cost of sales Trade Payables This ratio measures the number of times that trade payables are paid during the year. The higher the ratio, the faster the payment period. Speed of payments will obviously be impacted by the nature of creditors and payment terms. A high rate may indicate that the company is paying suppliers quickly to take advantage of discounts. A lower rate could indicate that the company has slowed paying suppliers, which could lead to strained supplier relations. 4

5 Days Payables = 365 Payables Turnover Ratio This formula converts the Payables Turnover ratio into the average number of days that trade payables are outstanding. A high result could indicate that the company has slowed paying suppliers, which could lead to strained supplier relations. A low result could indicate that the company is paying suppliers quickly to take advantage of discounts. Coverage Ratios Coverage ratios reflect a company s ability to pay short-term debt obligations, including interest and current portions of long-term debt. These ratios are used by lenders in order to gain some level of comfort and understanding as to the company s viability. Times Interest Earned = Earnings Before Interest and Taxes Annual Interest Expense This ratio measures a company s ability to make its interest payments. A high ratio may indicate greater ease in meeting payment requirements. It may also indicate an improved ability to assume more debt. A low ratio may indicate increasing difficulties in meeting interest payments. Net Income + Depreciation / Current Portion of Long-Term Debt = Net Income + Depreciation, Depletion, Amortization Current Portion of Long-Term Debt This ratio measures a company s ability to generate sufficient cash to repay the current portion of long-term debt or take on additional debt. The ratio assumes that cash generated will be earmarked for debt repayment as opposed to other possible uses. 5

6 Leverage Ratios Leverage ratios help measure how much protection a company s assets provide to creditors given its level of debt. Debt / Equity = Total Liabilities Shareholder s Equity This ratio measures the extent that capital is contributed by creditors versus owners. The higher the ratio, the greater the company is leveraged, i.e.: the company is being increasingly supported by creditors, leaving it exposed to adverse changes in sales, interest rate increases or increased sales. A lower ratio may indicate stronger borrowing power. It may be less risky from a lender s standpoint, but may also indicate that the company may not be taking full advantage of debt as a means to grow the business. Operating Ratios Operating ratios tend to demonstrate company performance. They help assess how well sales are being converted into profits and how well assets are being used to generate profits. Sales Annual Growth Rate = Current Year Sales Previous Year Sales Previous Year Sales This formula measures the annual growth rate in sales over the previous year. Gross Margin = Gross Profit Sales Perhaps one of the most common ratios used to assess profitability before selling, general & administrative and financial expenses. Gross margins can vary widely, depending on the business strategy being deployed and the magnitude of expenses below the line that must be covered. 6

7 Pretax Profit Margin = Net Income Before Taxes Operating Revenues This ratio measures a company s ability to control costs relative to sales revenue and pricing policies. A high ratio indicates overall good financial performance. A low ratio may indicate poor sales, gross profit or expense management. Percent Return on Equity = Net Income Before Taxes Shareholder s Equity This ratio measures the rate of return on equity. It is often considered as one of many indicators of management performance. A high ratio is generally positive, However, it could also indicate that a company may be under capitalized. A low ratio may indicate poor performance or a highly capitalized company with a strong equity position. There can be many causes for shifts in Return on Equity. As a result, the formula can be split into three components in order to better identify underlying changes. This formula is known as the DuPont Formula, or the Strategic Profit Model: (A) (B) (C) = Net Income Before Taxes X Sales X Total Assets Sales Assets Average Shareholder s Equity By combining Return on Equity with these other ratios, or by breaking down Return on Equity into these three components, changes become easier to understand, i.e.: Is the return improving because of improvements in net margin (part A)? Is the return improving because more sales are being generated given the level of assets deployed (part B)? Is the debt equity mix better managed, so as to better generate earnings (part C)? 7

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