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МММЈЈЈЈЈЈџџџџAnalyzing Your Financial Ratios
Section 1: Any successful business owner is constantly evaluating the performance of his or her company. Ratios are highly useful tools that can help you evaluate the financial health of your business. Ratio analysis is primarily used to compare companys financial figures over a period of time and they are used by bankers, potential investors, financial analysts and creditors to learn about the financial condition of your company. This workshop focuses on four types of ratios used in financial analysis. There are many more than whats being covered in this workshop and, frankly, it can become overwhelming so we picked the ratios that are most relevant to a small business. Please contact your accountant or financial advisor for more information on this topic. The ratios we are covering in this workshop focus on liquidity, operations, profitability and a working capital. The purpose of analyzing financial ratios is to enable you to answer the following critical questions about the financial health of your business.
Section 1 Click 1: Before we begin, take a moment and review some important factors to keep in mind when analyzing financial ratios. When you are finished reading, click on the continue button to get started.
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Section 2: The first series of ratios we are going to look at are called liquidity ratios which measure whether your company is able to meet short-term obligations with cash or other assets that can be quickly converted to cash. Too little liquidity raises the possibility of default and bankruptcy while too much liquidity may mean that long-term investments with greater profitability have been missed. These ratios are most helpful for short-term creditors, suppliers and bankers but theyre also important to financial managers who must meet obligations to various government agencies and creditors. Before reading on, ask yourself the following questions. If youre not sure of any of the answers, you may want to consider one of the following two ratios, current ratio and the quick test ratio, also known as the acid test.
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Section 2 Click 1: Current ratio tells you whether your businesss assets can cover its liabilities. This ratio is important if you plan on borrowing money or obtaining credit from suppliers. By most standards a healthy current ratio is around 2:1, meaning the company has twice as many assets as liabilities. Lower numbers may mean you have solvency issues, while high numbers may mean there is too much cash on hand that could be put to better use in a long-term investment. Calculate your current ratio by using the following equation.
Section 2 Click 2: The quick test ratio goes one step beyond the current ratio in measuring liquidity because it excludes inventories and only examines liquid assets in relation to liabilities. In other words, it assesses your companys ability to come up with immediate cash. Potential creditors and investors like to use this ratio because it reveals a companys ability to pay debts under the worst possible conditions. A quick ratio of 1:1 is desirable. It means that you have 1 dollars worth of easily converted assets for each dollar of current liabilities. Lower numbers signify poor liquidity, while higher numbers may mean you have idle funds that could be put to better use. Your most current balance sheet holds the numbers youll need to calculate your companys quick ratio. Use the following equation.
Section 2 Click 3: Take a look at the example for a better understanding of how these ratios work. When youre finished reading, click on the continue button.
Section 3: The next two ratios well look at are called the operating profit percentage ratio and the inventory turnover ratio. Well start with the operating profit percentage ratio. This ratio tells you the percentage of your sales that turn into profit. The ratio excludes miscellaneous income and tax expenses so the calculation produces and accurate picture of your primary business. If you see the number getting smaller over time, you may want to re-evaluate your pricing strategy or operating expenses. Your income statement provides you with the numbers youll need to calculate the following equation.
Section 3 Click 1: Now, lets look at your inventory turnover ratio. This formula tells you how often your inventory is depleted and replenished each year. Because inventories are your least liquid assets, they are at risk of losing value over time as they sit waiting to be sold and, therefore, high turnover rate is usually a good thing. If your inventory turnover is exceptionally high compared to your industry average, it could mean that your business is losing sales because of inadequately stocked items. A good rule of thumb is to multiply your inventory turnover by your gross margin percentage. If the result is 100% or greater, your average inventory is sufficient. Calculate your inventory turnover ratio by using the following equation.
Section 4: The next series of ratios looks at your companys profitability. At the end of the day, the goal of doing business is making a profit. Profitability ratios attempt to show you how well the firm did, given the level of risk and types of risks it actually assumed during the year. Profitability ratios gauge the overall effectiveness of management regarding the returns they generate on sales and investment. Before reading on, ask yourself the following questions. If youre not sure of any of the answers, consider the following ratios to help you.
Section 4 Click 1: The first ratio is called gross profit margin. Gross profit margin is one of your key performance and efficiency indicators and should be stable over time. Large swings can be a sign of accounting errors or deceit. Be on the lookout for downward trend in GPM since this can be a sign of lagging productivity and future problems for your bottom line. Note, however, that GPM rates can and will vary greatly from business to business, even those within the same industry. Sales, location, size of operations and intensity of competition are all factors that can affect the gross profit rate. A gross profit margin of .30:1 means that for every dollar in sales you have 30 cents to cover your basic operating costs. Calculate your gross profit margin by using the following equation.
Section 4 Click 2: Next ratio is called net profit margin. This ratio measures profitability as a percentage of revenues after considering all of your revenues and expenses, including interest expenses, non-operating items and income taxes. In other words, it shows you how much profit your company makes on every dollar in revenue it generates. Tracking this ratio over time is vital. While variation in NPM from one year to the next may be due to extraordinary conditions or expenses, a steady ongoing decline may mean that productivity needs a boost. Calculate your net profit margin by using the following equation.
Section 4 Click 3: Lets look at another case study to see these ratios in action.
Section 4 Click 4: Another profitability ratio is called return on assets. ROA measures how much profit your company generates per each dollar in assets it owns. A low ROA means that a business relies very heavily on operating assets and earns a small return on them. Large manufacturers and transportation and utility companies fall into this category. A high ROA means that the company is less asset dependent. Consulting firms, beauty salons, and other service-oriented businesses fall into this category. ROA often measures how well a companys management team is doing its job. Investors use this ratio to evaluate a companys leadership. Calculate your return on assets by using the following equation.
Section 4 Click 5: The last profitability ratio well discuss is called a management rate of return. This profitability ratio, which you may calculate for your entire company or for each of its divisions or operations, determines whether you have made efficient use of your assets. It compares operating income to operating assets, which are defined as the sum of tangible fixed assets and networking capital. The percentage should be compared with a target rate of return that you have set for your business. Calculate your management rate of return ratio by using the following equation.
Section 5: The last series of ratios well focus on are called working capital ratios. Many people believe increased sales can solve any business problem and often they are correct; however, sales must be built upon sound policies concerning other current assets and should be supported by sufficient working capital. There are two types of working capital, gross working capital, which includes all current assets, and networking capital, which is current assets less current liabilities. If you find that you have inadequate working capital, you can correct it by lowering sales or by increasing current assets through either internal savings or external savings. Before reading on, ask yourself the following questions. If you are not sure of any of the answers, consider the following ratios to help you.
Section 5 Click 1: The first ratio we will look at is called working capital. Your working capital position provides you with a snapshot of your current financial condition. If you were forced to liquidate your short-term assets to meet short-term obligations, the more working capital your company has, the less likely it will need to borrow money to meet those obligations. Calculate your working capital by using the following equation.
Section 5 Click 2: The next ratio is called debt-to-net worth. This ratio measures the proportion of funds that short and long-term creditors contribute to your operations. Your business should not have debt that exceeds your invested capital. For small business, a ratio of 60% or above usually spells trouble. Calculate your debt-to-net worth by using the following equation.
Section 6: For additional information on this topic, click on the Resource and Worksheet buttons at the top of the page. To talk with peers or an expert on this subject, click on the Discuss and Ask the Expert sections at the top of the page. Good Luck!
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