Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.
Balance Sheet Ratio Analysis Formula
Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors' funding). They include the following ratios:
Liquidity Ratios
These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.
Current Ratios. The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:
Current Ratio =
Total Current Assets
____________________
Total Current Liabilities
The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.
If you decide your business's current ratio is too low, you may be able to raise it by:
• Paying some debts.
• Increasing your current assets from loans or other borrowings with a maturity of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.
Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is figured as shown below:
Quick Ratio =
Cash + Government Securities + Receivables
______________________________________
Total Current Liabilities
The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick' funds on hand?"
An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.
Working Capital. Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:
Working Capital = Total Current Assets - Total Current Liabilities
Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements.
AÂ general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are relying to any significant extent on creditor money to finance assets.
Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner's equity):
Debt/Worth Ratio =
Total Liabilities
_______________
Net Worth
Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.
Income Statement Ratio Analysis
The following important State of Income Ratios measure profitability:
Gross Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company.
Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows:
Gross Margin Ratio =
Gross Profit
_______________
Net Sales
(Gross Profit = Net Sales - Cost of Goods Sold)
Net Profit Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company's "return on sales" with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:
Net Profit Margin Ratio =
Net Profit Before Tax
_____________________
Net Sales
Management Ratios
Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information.
Inventory Turnover Ratio
This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:
Inventory Turnover Ratio =
Net Sales
___________________________
Average Inventory at Cost
Accounts Receivable Turnover Ratio
This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is calculated as follows:
Net Credit Sales/Year
__________________ = Daily Credit Sales
365 Days/Year
Accounts Receivable Turnover (in days) =
Accounts Receivable
_________________________
Daily Credit Sales
Return on Assets Ratio
This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows:
Return on Assets =
Net Profit Before Tax
________________________
Total Assets
Return on Investment (ROI) Ratio.
The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows:
Return on Investment =
Net Profit before Tax
____________________
Net Worth
These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business's relative strengths and weaknesses.
Current Ratio
Current ratio is the ratio of current assets of a business to its current liabilities. It is the most widely used test of liquidity of a business and measures the ability of a business to repay its debts over the period of next 12 months.
Formula
Current ratio is calculated using the following formula:
Current Ratio = Current Assets
Current Liabilities
Both the above figures can be obtained from thebalance sheet of the business. Current assets are the assets of a business expected to be converted to cash or used up in next 12 months or within the normal operating cycle of the business. Current liabilities on the other hand are the obligations of a business which need to be settled within next 12 months or within the normal operating cycle.
Analysis
Current ratio matches current assets with current liabilities and tells us whether the current assets are enough to settle current liabilities. Current ratio below 1 shows critical liquidity problems because it means that total current liabilities exceed total current assets. General rule is that higher the current ratio better it is but there is a limit to this. Abnormally high value of current ratio may indicate existence of idle or underutilized resources in the company.
Examples
Example 1: On December 31, 2009 Company A had current assets of $100,000 and current liabilities of $50,000. Calculate its current ratio.
Solution
Current ratio = $100,000 ÷ $50,000 = 2.00
Example 2: On December 31, 2010 Company B had total asset of $150,000, equity of $75,000, non-current assets of $50,000 and non-current liabilities of $50,000. Calculate the current ratio.
Solution
To calculate current ratio, we need to calculate current assets and current liabilities first:
Current Assets = Total Asset − Non-Current Assets = $150,000 − $50,000 = $100,000
Total Liabilities = Total Assets − Total Equity = $150,000 − $75,000 = $75,000
Current Liabilities = $75,000 − $50,000 = $25,000
Current Ratio = $100,000 ÷ $25,000 = 4.00
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