Financial Ratio Analysis
April 19, 2010
Karen Snow
Financial ratios are a great way to see a snapshot of the company finances. While a ratio analysis reports historical information, ratios can be predictive and provide a leading indicator of results to come if the company remains on the same path. For ratios to be most effective, they need to be calculated and reviewed over a period of time to establish trends. Through this trend analysis, management is able to identify areas that either are improving or need to improve.
Determining which ratios to track depends on your industry, the age of the company and specifics inherent to your business cycle. If your company employs a large number of fixed assets, ratios related to the efficient use of those assets are important. If your company has challenges related to cash management, executives should watch ratios indicating the ability to meet cash service needs.
Some standard financial ratios are:
CURRENT RATIO: Current Assets
Current Liabilities
One of the oldest and most used ratios, the current ratio is used to measure the company’s ability to meet current obligations with current assets.
RETURN ON ASSETS: Net Income
Average Total Assets
This ratio measures how profitable a company is relative to its total assets. The benchmark varies from industry-to-industry as a service company would not have as much invested in fixed assets as would a capital intensive manufacturing company.
DEBT TO EQUITY: Total Liabilities
Shareholder Equity
Debt to equity is a measurement of leverage. It compares ‘what is owed’ to ‘what is owned.’ There cannot be a rule of thumb or standard norm for all types of businesses. A high ratio may indicate less protection for creditors while a low ratio may indicate an inefficient use of debt.
DAY’S SALES OUTSTANDING: Receivables
Average Credit Sales per Day
The day’s sales outstanding ratio (DSO) gives an indication of how long it takes to collect accounts receivables. As a rule of thumb, DSO should not exceed regular terms times 1-1/3 to 1 ½. That is, if terms are 30 days, a good DSO is 40 to 45 days.
Ratios that are less common but provide valuable information include:
BASIC DEFENSIVE INTERVAL: Cash + Receivables + Liquid Assets
(Operating Expenses + Interest + Income Tax) / 365
The BDI indicates how many days the company can service cash expenses without drawing on additional financing should revenues cease.
SUSTAINABLE GROWTH RATE: ROE x (1 – Dividend Payout Ratio)
ROE (Return on Equity) = Net Income / Shareholders Equity
Dividend Payout Ratio = Dividends / Net Income
Sustainable growth rate is the rate at which a company can grow without investing more capital or by increasing debt or equity financing. A company can grow at the same rate that it retains its earnings (income less dividends) to the extent that the opportunity to grow is present. If a company has a 20% Return on Equity (ROE) and pays 30% of its earnings as dividends, its sustainable growth rate is 14% which is calculated as 70% (1-30%) times 20%.
MANAGEMENT RATE OF RETURN: Operating Income
Net Working Capital + Fixed Assets
The Management Rate of Return is used to measure the efficient use of assets and answers the question, how well is the company using its assets to generate a profit. It can be calculated on an entire company or on divisions or cost centers. It can be compared to prior periods to determine trends or can be benchmarked against a target rate of return.
To help ensure viability and success in a business, owners and management must constantly evaluate performance by tracking historical trends and comparatives to prior periods and / or to budgets or projections. An effective owner or manager will be able to analyze the data and identify strengths and weaknesses in the financial statements and to react to both positive and negative trends. The first step in attaining this confidence is to have access to critical financial data in a timely manner.