Financial Ratios

Ratio A mathematical relationship between two elements, derived by dividing one into the other (e.g., the current ratio results from dividing current assets by current liabilities). analysis is an excellent method for determining the overall financial condition of a customer's business. Ratios are useful for making comparisons between a customer and other businesses in an industry. A financial ratio is a simple mathematical comparison of two or more entries from a company's financial statements The balance shee A financial statement listing the assets, liabilities and owner's equity of a business entity as of a specific date. t, income statement, statement of changes in financial position, statement of changes in owners' equity accounts, cash flow statement and notes. . 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 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 An expression of a firm's ability to pay its current debts by dividing current assets by current liabilities. , Quick Ratio, and Working Capital The net assets of an individual enterprise, partnershi A partnership is defined as "an association of two or more persons to carry on as co-owners of a business for profit." While no particular form of contract is necessary to create a partnership, a partnership contract usually provides what the partners' ri p, corporation, including not only the original investment, but the gains and profits from the business. .

The Current ratio formula is: Current assets Cash or other assets that are expected to be converted to cash or sold or utilized within a year or less through the normal operations of a business. divided by current liabilities Debts or obligations that will be due in one year or less. .
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 less inventories) 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 Goods held for sale or leas A contract granting the use and possession of real property for a specified time and for fixed payments. e that are furnished under contracts of service, usually raw material Industrial products that are composed of farm and natural products. s, work in proces The direct material costs, the direct labor costs and the factory overhead costs, that have entered into the manufacturing process but are associated with products that have not been finished. s, or materials used or consumed in a business. .

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 A medium of exchange; coined or stamped currency. 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.
This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. A high debt to equity ratio could indicate that the company may be over-leveraged, and should look for ways to reduce its debt.

The interest Compensation for the use of money. coverage ratio formula is: Earnings before Interest, Taxes, Depreciation An accounting technique by which management gradually recovers the cost of expensive fixed assets over the course of their expected lives. and Amortization divided by Interest Expense.
This ratio indicates what portion of debt interest is covered by a company's cash flow situation.

Profitability ratios

Profitability refers to a company's ability to generate revenues in excess of the costs incurred in producing those revenues.

The Gross profit margin formula is: Gross Profit The excess of net over the cost of merchandise sold. 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.

The Return on sales formula is: Net profit divided by sales.
This ratio compares after tax profit to sales. It can help you determine if you are making enough of a return on your sales effort

The return on equity ratio formula is: Net income divided by Shareholders A corporation's owners but frequently not the individuals who control and manage the firm day by day. equity
It indicates what return a company is generating on the owners' investment.

The return on assets formula is: Net Income divided by Average Any partial loss or damage due to insured perils. Total Assets.
The higher the percentage rate that a company has the better.
Efficiency ratios Ratios used to measure how efficiently a business uses and controls its assets.

The Payables turnover The number of times that assets, such as inventory or accounts receivable, are replaced on average during the period. ratio formula is: Cost of sales divided by trade payables
This number 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

The Average collection period formula is: Accounts receivable A claim against a customer for services rendered or goods sold on credit. 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 Return on assets (ROA) ratio formula is: Earnings before interest and taxes (EBIT) divided by net operating assets. This number tells you how effective your business has been 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 implies that the firm is using its assets efficiently.*

*Source: Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.

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