Business Ratios are Indicators of Company Health

posted on 17 Jun 2014 17:25 by assortedphiloso06
Business Ratios are Analytical ToolsRatio analysis is a process that incorporates a series of simple mathematical functions and applies them to financial statements or projections to determine fiscal performance and conditions of a business enterprise.

One commonly-used business ratio is Business Profitability, calculated by dividing net profit before tax by the total value of capital employed.

To see the original article together with any other images or videos, navigate to the link previously mentionedThe Institute of Chartered Accountants explains the use of this ratio: "This can then be compared with what the same amount of money (loans and shares) would have earned on deposit or in the stock market." ('Balance Sheets: The Basics', businesslink.gov.uk, accessed 25 May 2010)

Ratios become even more valuable when they can be used as business tools and compared over several years, from one period to the next. The most popular use of business ratios is to compare a company's ratio with those of other businesses in the same industry.

Sales to Inventory Ratio

The Sales to Inventory ratio is annual sales (in units of currency) divided by the value of the inventory. Peter J. Patsula, author of 'Successful Business Planning in 30 Days', says that a company's sales to inventory ratio should probably be around 6 to 1, which means the business needs to order inventory about six times per year.

"This ratio is commonly referred to as your 'Inventory Turnover' ratio. This ratio will be higher if you sell consumables and lower if you sell expensive items like jewellery or cars." ('Understanding Business Ratios,' zeromillions.com, accessed 25 May 2010)

Current Ratio

The Current Ratio is the value of total current assets divided by the company's total current liabilities. This is a liquidity ratio which indicates how well the company can cover its short-term debt with all its current assets.

For example, a company has total current assets of $100,000 and total current liabilities of $75,000. Apply the formula as follows:

Total Current Assets $100,000/Total Current Liabilities $75,000 = 1.33.

The result indicates the company has $1.33 of current assets for every dollar of current liability. Many companies try to maintain a ratio of 2.0 or better, although less can be acceptable.

The Acid Test

The Acid Test (or 'quick' ratio) is total current assets (minus inventory) divided by total current liabilities. The acid test takes the current ratio one step further for companies with inventories and indicates how well the business can cover its short-term liabilities with current assets excluding inventory.

In calculating this ratio, inventory is eliminated because it represents the segment of current assets that will be the most difficult to liquidate immediately and turn into cash. The Acid Test for a company with $100,000 in total current assets, of which $25,000 is inventory and $75,000 is current liabilities, is calculated as:

Total Current Assets - Inventory ($100,000 - $25,000)/Total Current Liability ($75,000) = 1.0.

This indicates the company has $1.00 of current assets (minus inventory) to pay for each dollar of current liability. This ratio should always equal 1.0 or more.

Debt Ratio

The Debt Ratio is total debt divided by the value of total assets. This ratio indicates how much a company is reliant on borrowing to finance its operations. A company that has a total debt of $25,000 and total assets of $200,000 calculates its debt ratio as:

Total Debt $25,000/Total Assets $200,000 = .121

This equates to 12.1 cents in debt for every dollar of total assets. This is a healthy ratio in most industries, although the acceptable ratio level varies by industry.

Debt-to-Equity Ratio

The Debt-to-Equity ratio is total debt divided by total equity (or net worth).

A company that has a total debt of $25,000 and a total equity of $25,000 calculates its debt-to-equity ratio as:

Total Debt ($25,000)/ Total Equity ($25,000) = 1.0

This company has $1.00 of debt for every dollar of total equity. A debt-to-equity ratio of 1.0 is considered excellent in many industries, although the average ratio varies from one industry to the next. There are many other more specialized ratios that can be applied to almost any business, including some related to business activity. An example of this is the Collection Days Ratio.

As author and co-founder of Borland International, Tim Berry describes on the Business Plans website, this ratio is calculated by multiplying Accounts Receivable by 360, which is then divided by annual Sales on Credit: "Generally, 30 days is exceptionally good, 60 days is bothersome, and 90 days or more is a real problem." ('Business Ratios,' bplans.co.uk, accessed 25 May 2010)

Ratios Become Comparison Benchmarks

Once a company determines its own ratios, it can use benchmarks to compare them against other businesses in the same industry.

A calculator for many commonly-used ratios is available online and enables any business to quickly calculate debt ratios, profitability ratios and liquidity ratios that can be compared to standardized industry benchmarks.

Ratios are invaluable business management tools for comparing the performance of companies on a like-for-like basis.

The relative profitability, growth or debt levels of differently-sized companies can be directly measured or compared so that the management of a business has an indication of how their own company is performing relative to others in the same industry.

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