KEY BUSINESS RATIOS ANALYSIS Valuable insights into an industry's performance can be obtained by equating two related statement items in the form of a financial ratio. For really effective ratio analysis, the items compared must be meaningful and the comparison should reflect the combined effort of two potentially diverse trends. While dozens of different ratios can be computed from financial statements, the ten included in Business Profiles are among those more commonly used. Many other ratios in existence are variations on these ten. The ten key business ratios can be categorized into the three major groups solvency, efficiency and profitability. Solvency or liquidity measurements are significant in evaluating a company's ability to meet short and long-term obligations. These figures are of prime interest to credit managers of commercial companies and financial institutions. Efficiency ratios show how effectively a company uses and controls its assets. This is crucial information for evaluating how a company is managed. Studying these ratios is useful for credit, marketing and investment purposes. Profitability ratios show how successfully a business is earning a return for its owners. Those interested in mergers and acquisitions consider this key data for selecting candidates. THE 10 KEY BUSINESS RATIOS SOLVENCY CURRENT RATIO Total current assets are divided by total current liabilities. Current assets include cash, accounts and notes receivable (less reserves for bad debts), advances on inventories, merchandise inventories, and marketable securities. This ratio measures the degree to which current assets cover current liabilities. The higher the ratio the more assurance exists that the payment of current liabilities can be made. Normally a ratio of 2 to 1 (2.0) or better is considered good. CURRENT LIABILITIES TO NET WORTH (OWNER'S EQUITY) Current liabilities to net worth are derived by dividing current liabilities by net worth. This contrasts the funds that creditors temporarily are risking with the funds permanently invested by the owners. The smaller the net worth and the larger the liabilities, the less security for the creditors involved.
Dividing current liabilities by inventory yields another indication of the extent to which the business relies on funds from disposal of unsold inventories to meet its debts. This ratio combines with Net Sales to Inventory to show how management controls inventory. It is possible to have decreasing liquidity while maintaining consistent sales-to-inventory ratios. TOTAL LIABILITIES TO NET WORTH Obtained by dividing total current plus long-term and deferred liabilities by net worth. The effect of long-term (funded) debt on a business can be determined by comparing this ratio with Current Liabilities to Net Worth. The difference will pinpoint the relative size of long-term debt, which, if sizable, can burden a firm with substantial interest charges. FIXED ASSETS TO NET WORTH Fixed assets are divided by net worth. The proportion of net worth that consists of fixed assets will vary greatly from industry to industry, but generally a smaller proportion is desirable. A high ratio is unfavorable because heavy investment in fixed assets shows that either the concern has a low net working capital and is over-trading or has used large funded debt to supplement working capital. Also, the larger the fixed assets, the bigger the annual depreciation charge deducted from the income statement. EFFICIENCY COLLECTION PERIOD Accounts receivable are divided by sales and then multiplied by 365 days to obtain this figure. The quality of the receivables of a company can be determined by this relationship when compared with selling terms and industry norms. Generally, where most sales are for credit, any collection period more than one-third over normal selling terms (40 for 30 day terms) indicates some slow-turning receivables. When comparing the collection period of one concern with that of another, allowances should be made for possible variations in selling terms. NET SALES TO INVENTORY Obtained by dividing annual net sales by inventory. Inventory control is a prime management objective since poor controls allow inventory to become costly to store, obsolete or insufficient to meet demands. Individual figures that are outside either the upper or lower quarterlies for a given industry should be examined with care. Although low figures are usually the biggest problem, as they show excessively high inventories, extremely high turnovers might reflect insufficient merchandise to meet customer demand and result in lost sales. SALES TO NET WORKING CAPITAL Net sales are divided by net working capital. (Net working capital is current assets minus current liabilities). This relationship indicates whether a company is overtrading or conversely carrying more liquid assets than needed for its volume. Companies with substantial sales gains often reach a level where their working capital becomes strained. PROFITABILITY RETURN ON SALES Return on Sales (Profit Margin) is obtained by dividing net profit after taxes by annual net sales. This reveals the profits earned per dollar of sales and therefore measures the efficiency of the operation. Return must be adequate for the firm to achieve satisfactory profits for its owners. RETURN ON NET WORTH (EQUITY) Return on Net Worth (Return on Equity) is obtained by dividing net profit after taxes by net worth. This ratio is used to analyze the ability of the firm's management to realize an adequate return on the capital invested by the owners of the firm. The tendency is to look increasingly to this ratio as a final criterion of profitability. Generally, a relationship of at least ten percent is regarded as a desirable objective for providing dividends plus funds for future growth. Source: Dun & Bradstreet "Industry Norms and Key Business Ratios" |
