Ratio Analysis: Not Just For Accountants
June 23, 2016
Ratio analysis sounds complicated and high level for a non-accountant. In fact, it sounds downright scary! Ratio analysis, however, is another tool for owner's to use in analyzing their businesses and assessing effectiveness in certain areas. It is a way to obtain quick indications of a business' financial performance.
Ratios can highlight trends and provide assistance in identifying and quantifying some of a business' strengths and weaknesses. This can be done on an absolute basis meaning looking at the company by itself, comparing different accounting periods, and reviewing trends. Ratio analysis can also be used to compare one business to other businesses or norms in the same industry.
What Ratio To Use
There can be a ratio for practically anything that an owner wants to review. It is important, however, to be practical. Owners should use ratios that are easy for them to understand, and those that are most important in helping the business run more efficiently and profitably.
Rather than owners getting submerged with ratios that do not make sense to them, they should study the most popular ratios and then pick those that assist them to make better business decisions. Some ratios are more appropriate for some businesses than others. Good advice is to work with a couple of ratios that are most pertinent to the business until a comfort level is achieved before adding more ratios to a financial analysis review.
Some of the most popular ratios used for small business analysis are:
• Current Ratio
• Acid-Test or Quick Ratio
• Working Capital
• Accounts Receivable Turnover Ratio
• Inventory Turnover Ratio
• Debt to Equity Ratio
• Times Interest Earned Ratio
• Profit Margin Ratio
What Do The Results Show
There are no precise ratio measurements that unequivocally equate to being either positive or negative for a business. There are generalized statements that can be made for each ratio, but the ratio has to be compared to previous accounting periods and/or compared to industry averages to obtain the most value from performing the calculation. The easiest and quickest way to analyze any ratio is to understand its trend. Is it increasing or decreasing? Is it getting better or worse? Setting up a simple spreadsheet is an excellent way to review ratio trends. List the name of the ratio on the left side of a spreadsheet going down with the most current accounting period in the left column at the top. Each subsequent accounting period can be added to the next column to the right on the spreadsheet. Soon, a complete history or trend of the ratios is viewable to the reader.
Quick Summary And Calculation
Current Ratio = Current Assets / Current Liabilities
This is a measure of a company's ability to meet its current obligations on time and considered to be a short-term liquidity ratio.
Acid-Test or Quick Ratio =
Cash, Cash Equivalents, & Accounts Receivable / Current Liabilities
This is another liquidity ratio or measure of a company's ability to meet its current obligations. The difference between this ratio and the current ratio is that the acid-test or quick ratio excludes inventory since it normally takes time for inventories to work through the sales process and be converted into cash.
Working Capital = Current Assets – Current Liabilities
This ratio is a direct indicator of a company's ability to grow. In other words, are current assets rising at a faster pace than the current liabilities giving the business available capital to fund operations and purchase inventory.
Accounts Receivable Turnover Ratio =
Total Credit Sales / Average Accounts Receivable Balance
This ratio calculates the number of times it takes total receivables to turn into cash in a year. Basically, it quantifies how effective a business is at extending credit as well as collecting on credit sales.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Balance
It is important for businesses that carry inventory to "turn" the inventory as rapidly as possible. This ratio calculates the number of times the average inventory balance is sold during the accounting period.
Debt to Equity Ratio = Total Liabilities / Total Equity
This ratio is an indicator of the relationship between company owners and creditors. It shows the amount of protection that owners provide to creditors and is indicative of the financial safety of a business.
Times Interest Earned Ratio =
Income Before Interest Expense & Income Taxes / Interest Expense
This is sometimes referred to as the interest coverage ratio. It is designed to measure a company's ability to meet interest payments, and one that creditors would be most interested in.
Profit Margin Ratio = Net Income / Net Sales
This ratio reflects a measure of how efficient a business is at producing sales and turning those sales into net profit.