Ratio analysis is a very useful tool to quantitatively understand a business's performance. While many managers shy away from ratio analysis, the calculation thereof is not difficult, and it only requires information from the company's financial statements.
What Is Ratio Analysis?
Ratio analysis is a method by which a company’s operations can be quantitatively evaluated and measured using the balance sheet, the income statement and the cash flow statement. Ratio analysis can be used to determine whether a business is profitable, whether it has enough to pay its bills, whether it is using its assets efficiently and whether it is a good candidate for investment. Ratio analysis facilitates the spotting of trends and provides a way to compare a business with others in its industry.
Balance Sheet Ratios
Ratios calculated using information from the balance sheet, also called liquidity ratios, indicate the ability of a company to turn its assets into cash. They include current ratios, quick ratios and leverage ratios.
The current ratio is one of the best-known measures of financial strength. It indicates whether a company has enough assets to pay off its debt. A generally acceptable ratio is 2:1, but this will vary based on the business itself, its stage in the business lifecycle, etc.
Current Ratio = Total Current Assets/Total Current Liabilities
Quick ratios are sometimes called "acid tests" and are one of the best measures of liquidity. It is more precise than the current ratio because it excludes inventories, focusing instead on truly liquid assets such as those listed in the formula. An acid-test of 1:1 is considered satisfactory. Quick Ratio = (Cash + Government Securities + Receivables)/Total Current Liabilities
Leverage ratios look at the extent to which a business is financed by debt. A high leverage ratio may indicate a risky business. Leverage Ratio = Total Liabilities/Net Worth
Working capital, although more a measure of cash flow than a ratio, is looked at frequently by banks and financial institutions when evaluating loan applications. It is viewed as the company’s ability to meet crises. Working Capital = Total Current Assets – Total Current Liabilities
Income Statement Ratios
Income statement ratios measure profitability. Comparison of these business ratios to those of similar businesses can reveal the relative strengths or weaknesses. Gross Profit = Net Sales – Cost of Goods Sold Gross Margin Ratio = Gross Profit/Net Sales Net Profit Margin Ratio = Net Profit Before Tax/Net Sales
These ratios are derived from information in both the balance sheet and the income statement.
The inventory turnover ratio reveals how well inventory is being managed. Inventory Turnover Ratio = Net Sales/Average Inventory at Cost
The accounts/receivable turnover ratio indicates how well receivables are being collected. A/R Turnover Ratio = Accounts Receivable/(Annual Net Credit Sales/365)
The return on assets (ROA) ratio measures how efficiently assets are being used.
ROA = Net Profit Before Tax/Total Assets
The return on investment (ROI) ratio reflects the return received on funds invested in the business. ROI = Net Profit Before Tax/Net Worth
Cash Flow Ratios
These ratios tend to be favored more by analysts than auditors. They are used to evaluate risk and can provide a more accurate determination of a company to satisfy its current and future obligations. Cash flow ratios are useful in highlighting potential problem areas
Operating cash flow (OFC) is the company's ability to generate resources to meet current liabilities. OCF = Cash Flow From Operations/Current Liabilities
Funds flow coverage (FFC) indicates the coverage of unavoidable expenditures. FFC = Earning Before Interest, Tax, Depreciation and Amortization (EBITDA)/(Interest + Debt Repayment + Preferred Dividends)
Cash interest coverage (CIC) is the ability of the company to meet interest payments. CIC = (Cash Flow From Operations + Interest Paid + Taxes Paid)/Interest Paid
Cash current debt coverage (CCDC) is the ability of the company to repay its current debt.
CCDC = (Operating Cash Flow – Cash Dividends)/Current Debt
Cash flow adequacy (CFA) is the basically the company’s credit quality. CFA = (EBITDA – Taxes Paid – Interest Paid – Capital Expenditures)/(5yr Average Annual Debt)
Renee O'Farrell is a freelance writer providing valuable tips and advice for people looking for ways to save money, as well as information on how to create, re-purpose and reinvent everyday items. Her articles offer money-saving tips and valuable insight on typically confusing topics. O'Farrell is a member of the National Press Club and holds advanced degrees in business, financial management, psychology and sociology.