Unlocking your business financial stability- Ratio Analysis
Ratio analysis falls under the general umbrella of financial analysis, which is defined as the selection, evaluation and interpretation of financial and other data to assist in the making of informed business decisions. Financial analysis may be used by internal stakeholders such as business owners and department heads to evaluate financial performance of a business division or make decisions on whether to discontinue ineffective programs or strategies. External stakeholders such as banks or prospective investors may use financial analysis to assess creditworthiness of an organization or to make investment decisions.
Ratios can be broken down into two types: effect and causal ratios. Effect ratios show what has happened, in other words, the financial outcome. Causal ratios on the other hand help to identify the underlying cause of the effect ratio. For the purpose of this article, we will be focusing on effect ratios.
Effect ratios can be divided into four categories:
Profitability ratios: measure profitability compared to size, margins and returns. They include:
- Gross profit ratio that measures product mark up. Computed as gross profit ÷ by sales.
- Return on sales measures the net profitability of each dollar of sales. Computed as net income ÷ by sales.
- Return on equity measures the net profitability of each dollar of equity investment. Computed as net income ÷ by equity
Operating ratios: measure an organization’s efficiency. They include:
- Total asset turnover ratio measures the effectiveness of an entity in using its assets during a period of time.Computed as net sales ÷ average total assets- Fixed asset turnover ratio measures the effectiveness of an entity in using fixed assets to generate revenues.
Computed as net sales ÷ total fixed assets
- Days sales Outstanding (DSO) measures the effectiveness of collections. Computed as Average accounts receivable ÷ total credit
sales × 365. It should be noted that average receivables is computed as the average of the beginning and ending receivables for the
the fiscal year.
- Days inventory outstanding (DIO)measures the average number of days it takes an organization to sell its inventory.
Computed as average (or ending ) inventory balance ÷ cost of goods sold × 365
- Days payable outstanding (DPO)measures the average number of days an organization takes to pay its vendors.
Computed as average (or ending) accounts payable × 365 ÷ cost of goods sold .
- Cash Conversion Cycle (CCC) measures the number of days it takes for a company to convert its investment in inventory into cash
flows from sales. It is computed as DSO+ DIO - DPO.
Liquidity ratios : measure how well an entity can pay for its short term obligations. The most frequently calculated liquidity ratios include:
- Current ratio. Computed as current assets ÷ current liabilities
- Quick ratio. Computed as (current assets - inventory) ÷ current liabilities
- Defensive interval ratio calculates how many days a company could continue to pay its normal expenses if it had no new source of
revenues. It’s the conservative measure of financial strength and the ability of the organization to weather a business disaster.
Computed as quick assets ÷ daily cash operating expenses. Quick assets are defined as cash, cash equivalents and marketable
securities that are readily available for sale. Daily cash operating expenses are defined as (annual operating expenses - depreciation
and amortization) ÷ 365.
- Cash flow adequacy ratio- measures the organization’s ability to cover its main cash requirements. Computed as cash from
operations ÷ (long term debt paid + assets acquired + dividends paid)
- Quality of liquidity ratio- measures the concentration of receivables and inventory in working capital. Computed as follows:
Inventory ÷ working capital- measures an organization’s investment in inventory.
Accounts receivable ÷working capital- measures the build up accounts receivable.
4. Leverage ratios : Measure debt usage and ability to afford debt. The most common leverage ratios are as follows:
- Debt to equity ratio computed as total liabilities ÷ total net worth
- Debt to assets ratio computed as total liabilities ÷ total assets
- Shareholder Equity ratio: measures how much of an entity’s assets have been generated by issuing equity shares as opposed
to taking on debt. Computed as Total shareholder equity ÷ total assets
- Times interest earned ratio- measures the ability of an organization to meet interest payments with current profits.
Computed as Earnings before interest and taxes(EBIT) ÷ interest expense
The desired trend directions of common ratios are as follows:
↑ Current ratio
↑ Quick ratio
↑ Defensive interval
↓ Days sales outstanding
↓ Days inventory outstanding
↓ Inventory to working capital
↓ Receivables to working capital
↓ Debt to net worth
↓ Debt to assets
↑ Times interest earned