Customer Financial Ratios; Ratio Analysis

Ratio analysis is an excellent method for determining the overall financial condition of a customer's business. Ratios help credit professionals to understand or to describe the financial condition of the company.  Ratios are useful in making comparisons between a customer and other businesses in an industry. A financial ratio is nothing more than a simple mathematical comparison of two entries from a company's financial statements. Creditors use ratios to chart a company's progress, uncover trends and point to potential problem areas.

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. Liquidity refers a company's ability to meet current obligations [to pay bills as they become due] with cash or other assets that can be quickly converted to cash. Liquidity Ratios give an indication of a company's short term financial or solvency. They include the Current Ratio, Quick Ratio, and Working Capital.

The Current Ratio formula is:  Current Assets divided by Current Liabilities.

The current ratio is one of the best-known measures of financial liquidity. The current ratio is the standard measure of any business' financial health. It will tell you whether your business is able to meet its current obligations by measuring if it has enough assets to cover its liabilities.

The Quick Ratio formula is: (Current Assets minusInventories) divided by Current Liabilities.

The quick ratio (also sometimes called the acid test ratio) measures a business' liquidity. However, many financial planners consider it a tougher measure than the current ratio because it excludes inventories when counting assets. It is a more strenuous version of the "current ration indicating whether current liabilities could be paid without selling inventory.  It is important for credit professionals to analyze the components of current assets in order to determine just how liquid these current assets are meaning how readily they can be converted into cash.

Leverage Ratios

Leverage ratios measure the relative contribution of stockholders and creditors. Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner's equity). Leverage Ratios which show the extent that debt is used in a company's capital structure.

The Debt to Equity ratio formula is: Total liabilities divided by Total Equity.  Debt to equity is also called debt to net worth. It quantifies the relationship between the capital invested by owners and investors and the funds provided by creditors. The higher the ratio, the greater the risk to a current or future creditor. A lower ratio means your client's company is more financially stable and is probably in a better position to borrow now and in the future.  This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned (Assets vs Liabilities). A high debt to equity ratio could indicate that the company may be over-leveraged, and that it should look for ways to reduce its debt.

The Interest Coverage ratio formula is: Earnings before Interest, Taxes, Depreciation and Amortization divided by Interest Expense.  Earnings before Interest Taxes, Depreciation and Amortization is known by its acronym, EBITDA.  The interest coverage ratio indicates how many times the company's EBITDA covers its interest expense.  EBITDA is essentially the money that a company has available to make interest payments.  As a general statement, the higher the ratio the better from the perspective of a trade creditor.  

Profitability Ratios

Profitability refers to a company's ability to generate revenues in excess of the costs incurred in producing those revenues.  Profitability ratios measure the company's ability to generate a return on its resources. An increase in these ratios is viewed as positive.

The Gross Profit Margin formula is: Gross Profit divided by Total Sales. The gross profit margin ratio indicates how efficiently a business is using its materials and labor in the production process. It shows the percentage of net sales remaining after subtracting cost of goods sold.  As a general rule, the higher the gross profit margin or gross margin, the better. 

The EBITDA Margin also analzes profitability.  EBITDA equals earnings before Interest Taxes, Depreciation and Amortization.  Its virtue is that EBITDA eliminates all non cash items from the profitability analysis.

Selling, General and Administrative Expenses are expenses or costs that are not specifically identifiable with or assigned to production. These include marketing and selling, research and development, and various administrative expenses.  The SG&A Margin measures how well a company manages its operating expenses relative to its sales.  The methodology used to calculate this margin is simply SG&A as a percent of Sales.  Not unexpectedly, the lower the margin, the more efficiently the company is managing its SG&A expenses in order to generate or maximize profits.

The Return on Sales formula is: Net Profit divided by Net Sales. This ratio compares after tax profit to sales. It can help you determine if the customer under review is making a sufficient return on sales.

The Return on Assets formula is: Net Income divided by Average Total Assets. This ratio evaluates how effectively a company employs its assets to generate a profit. The higher the percentage return, the better.  It is calculated by dividing a company's earnings for the period by its average total assets.

Efficiency Ratios

Efficiency Ratios help credit professionals to evaluate how well a company under review manages its assets.

The Payables Turnover Ratio formula is: Cost of Sales divided by Trade Payables.   This ratio reveals how quickly your company pays its bills. The payables turnover ratio reveals how often payables turn over during the year. A high ratio means there is a relatively short time between purchase of goods and services and payment for them.

The Inventory Turnover Ratio formula is: Cost of Goods Sold divided by Average Inventory.    In general, the higher the turnover ratio the better the company is performing.  This ratio shows how many times in an accounting period the company under review sells its inventory. Faster inventory turnover is considered positive.

The Average Collection Period formula is: Accounts receivable divided by (annual net credit sales divided by 365). This ratio will indicate how quickly your customers are paying their bills by revealing the average length of your collection period. It indicates the average number of days it takes a company to collect unpaid invoices.

The Accounts Receivable Turnover ratio shows the number of times accounts receivable are paid and reestablished during the accounting period. The higher the turnover, the faster the business is collecting its receivables.  The A/R Turnover formula is:  Total Net Sales  /  Accounts Receivable

The Return on Assets (ROA) ratio formula is: Earnings before Interest and Taxes (EBIT) divided by Net Operating Assets.

A company is operating efficiently if it generates an adequate return on investment with a minimum investment in assets.  The Return on Assets Ratio explains how effective the company underreviewhasbeen at putting its assets to work. The ROA is a test of capital utilization - how much profit (before interest and income tax) a business earned on the total capital used to make that profit. It indicates what return a company is generating on the firm's investments/assets.

The Asset Turnover formula is: Net sales divided by average Total Assets.  Asset turnover is an indicator of how efficiently a firm utilizes its assets. If the ratio is high it indicates that the company is using its assets efficiently. 

Source: Pam Faulk-Turnbull, Credit4Profit.com - Download Pam's financial spreadsheet in Excel.

Edited by Michael C. Dennis