Here are a few of the most important financial ratios for business owners to learn, what they tell you about the company’s financial statements, and how to use them.
The Balance Sheet for Financial Ratio Analysis
The Income Statement for Financial Ratio Analysis
Analyzing the Liquidity Ratios
The first ratios to use to start getting a financial picture of your firm measure your liquidity, or your ability to convert your current assets to cash quickly. They are two of the 13 ratios. Let’s look at the current ratio and the quick (acid-test) ratio.
The Current Ratio
The current ratio measures how many times you can cover your current liabilities. The quick ratio measures how many times you can cover your current liabilities without selling any inventory and so is a more stringent measure of liquidity. Remember that we are doing a time series analysis, so we will be calculating the ratios for each year. Current Ratio: For 2020, take the Total Current Assets and divide them by the Total Current Liabilities. You will have: Current Ratio = 642/543 = 1.18X. This means that the company can pay for its current liabilities 1.18 times over. Practice calculating the current ratio for 2021. Your answer for 2021 should be 1.31X. A quick analysis of the current ratio will tell you that the company’s liquidity has gotten just a little bit better between 2020 and 2021 since it rose from 1.18X to 1.31X.
The Quick Ratio
Quick Ratio: In order to calculate the quick ratio, take the Total Current Ratio for 2020 and subtract out Inventory. Divide the result by Total Current Liabilities. You will have: Quick Ratio = (642-393)/543 = 0.46X. For 2021, the answer is 0.52X. Like the current ratio, the quick ratio is rising and is a little better in 2021 than in 2020. The firm’s liquidity is getting a little better. The problem for this company, however, is that they have to sell inventory in order to pay their short-term liabilities and that is not a good position for any firm to be in. This is true in both 2020 and 2021. This firm has two sources of current liabilities: accounts payable and notes payable. They have bills that they owe to their suppliers (accounts payable) plus they apparently have a bank loan or a loan from some alternative source of financing. We don’t know how often they have to make a payment on the note.
Analyzing the Asset Management Ratios Accounts Receivable
Asset management ratios are the next group of financial ratios that should be analyzed. They tell the business owner how efficiently they employ their assets to generate sales. Assume all sales are on credit.
Receivables Turnover
Receivables Turnover = Credit Sales/Accounts Receivable = ___ X so:Receivables Turnover = 2,311/165 = 14X
A receivables turnover of 14X in 2020 means that all accounts receivable are cleaned up (paid off) 14 times during the 2020 year. For 2021, the receivables turnover is 15.28X. Look at 2020 and 2021 Sales in The Income Statement and Accounts Receivable in The Balance Sheet. The receivables turnover is rising from 2020 to 2021. We can’t tell if this is good or bad. We would really need to know what type of industry this firm is in and get some industry data to compare to. Customers paying off receivables is, of course, good. But, if the receivables turnover is way above the industry’s, then the firm’s credit policy may be too restrictive.
Average Collection Period
Average collection period is also about accounts receivable. It is the number of days, on average, that it takes a firm’s customers to pay their credit accounts. Together with receivables turnover, average collection helps the firm develop its credit and collections policy.
Average Collection Period = Accounts Receivable/Average Daily Credit Sales**To arrive at average daily credit sales, take credit sales and divide by 360
For 2020:
Average Collection Period = $165/2311/360 = $165/6.42 = 25.7 daysIn 2021, the average collection period is 23.5 days
From 2020 to 2021, the average collection period is dropping. In other words, customers are paying their bills more quickly. Compare that to the receivables turnover ratio. Receivables turnover is rising and the average collection period is falling. This makes sense because customers are paying their bills faster. The company needs to compare these two ratios to industry averages. In addition, the company should take a look at its credit and collections policy to be sure they are not too restrictive. Take a look at the image above and you can see where the numbers came from on the balance sheets and income statements.
Inventory, Fixed Assets, Total Assets
Inventory Turnover Ratio
The inventory turnover ratio is one of the most important ratios a business owner can calculate and analyze. If your business sells products as opposed to services, then inventory is an important part of your equation for success. Inventory Turnover = Sales/Inventory = ______ X If your inventory turnover is rising, that means you are selling your products faster. If it is falling, you are in danger of holding obsolete inventory. A business owner has to find the optimal inventory turnover ratio where the ratio is not too high and there are no stockouts or too low where there is obsolete money. Both are costly to the firm. For this company, their inventory turnover ratio for 2020 is: Inventory Turnover Ratio = Sales/Inventory = 2311/393 = 5.9X This means that this company completely sells and replaces its inventory 5.9 times every year. In 2021, the inventory turnover ratio is 6.8X. The firm’s inventory turnover is rising. This is good in that they are selling more products. The business owner should compare the inventory turnover with the inventory turnover ratio with other firms in the same industry.
Fixed Asset Turnover
The fixed asset turnover ratio analyzes how well a business uses its plant and equipment to generate sales. A business firm does not want to have either too little or too much plant and equipment. For this firm for 2020: Fixed Asset Turnover = Sales/Fixed Assets = 2311/2731 = 0.85X For 2021, the fixed asset turnover is 1.00. The fixed asset turnover ratio is dragging down this company. They are not using their plant and equipment efficiently to generate sales as, in both years, fixed asset turnover is very low.
Total Asset Turnover
The total asset turnover ratio sums up all the other asset management ratios. If there are problems with any of the other total assets, it will show up here, in the total asset turnover ratio. Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets = 2311/3373 = 0.69X for 2020. For 2021, the total asset turnover is 0.80. The total asset turnover ratio is somewhat concerning since it was not even 1X for either year. This means that it was not very efficient. In other words, the total asset base was not very efficient in generating sales for this firm in 2020 or 2021. Why? It seems to me that most of the problem lies in the firm’s fixed assets. They have too much plant and equipment for their level of sales. They either need to find a way to increase their sales or sell off some of their plant and equipment. The fixed asset turnover ratio is dragging down the total asset turnover ratio and the firm’s asset management in general.
Analyzing the Debt Management Ratios
There are three debt management ratios that help a business owner evaluate the company in light of its asset base and earning power. Those ratios are the debt-to-asset ratio, the times interest earned ratio, and the fixed charge coverage ratios. Other debt management ratios exist, but these help give business owners the first look at the debt position of the company and the prudence of that debt position.
Debt-to-Asset Ratio
The first debt ratio that is important for the business owner to understand is the debt-to-asset ratio; in other words, how much of the total asset base of the firm is financed using debt financing. For example. the debt-to-asset ratio for 2020 is: Total Liabilities/Total Assets = $1074/3373 = 31.8%. This means that 31.8% of the firm’s assets are financed with debt. In 2021, the debt ratio is 27.8%. In 2021, the business is using more equity financing than debt financing to operate the company.
Times Interest Earned Ratio
The times interest earned ratio tells a company how many times over a firm can pay the interest that it owes. Usually, the more times a firm can pay its interest expense the better. The times interest earned ratio for this firm for 2020 is:
Times Interest Earned = Earnings Before Interest and Taxes/Interest = 276/141 = 1.96XFor 2021, the times interest earned ratio is 3.35
The times interest earned ratio is very low in 2020 but better in 2021. This is because the debt-to-asset ratio dropped in 2021.
Fixed Charge Coverage
The fixed charge coverage ratio is very helpful for any company that has any fixed expenses they have to pay. One fixed charge (expense) is interest payments on debt, but that is covered by the times interest earned ratio. Another fixed charge would be lease payments if the company leases any equipment, a building, land, or anything of that nature. Larger companies have other fixed charges which can be taken into account.
Fixed charge coverage = Earnings Before Fixed Charges and Taxes/Fixed Charges = _____X
In both 2020 and 2021 for the company in our example, its only fixed charge is interest payments. So, the fixed charge coverage ratio and the times interest earned ratio would be exactly the same for each year for each ratio.
Analyzing the Profitability Ratios
The last group of financial ratios that business owners usually tackle are the profitability ratios as they are the summary ratios of the 13 ratio group. They tell the business firm how they are doing on cost control, efficient use of assets, and debt management, which are three crucial areas of the business.
Net Profit Margin
The net profit margin measures how much each dollar of sales contributes to profit and how much is used to pay expenses. For example, if a company has a net profit margin of 5%, this means that 5 cents of every sales dollar it takes in goes to profit and 95 cents goes to expenses. For 2020, here is XYZ, Inc’s net profit margin: Net Profit Margin = Net Income/Sales Revenue = 89.1/2311 = 3.9% For 2021, the net profit margin is 6.5%, so there was quite an increase in their net profit margin. You can see that their sales took quite a jump but their cost of goods sold rose. It is the best of both worlds when sales rise and costs fall. Bear in mind, the company can still have problems even if this is the case.
Return on Assets
The return on assets ratio, also called return on investment, relates to the firm’s asset base and what kind of return they are getting on their investment in their assets. Look at the total asset turnover ratio and the return on asset ratio together. If total asset turnover is low, the return on assets is going to be low because the company is not efficiently using its assets. Another way to look at the return on assets is in the context of the Dupont method of financial analysis. This method of analysis shows you how to look at the return on assets in the context of both the net profit margin and the total asset turnover ratio.
To calculate the Return on Assets ratio for XYZ, Inc. for 2020, here’s the formula:Return on Assets = Net Income/Total Assets = 2.6%
For 2021, the ROA is 5.2%. The increased return on assets in 2021 reflects the increased sales and much higher net income for that year.
Return on Equity
The return on equity ratio is the one of most interest to the shareholders or investors in the firm. This ratio tells the business owner and the investors how much income per dollar of their investment the business is earning. This ratio can also be analyzed by using the Dupont method of financial ratio analysis. The company’s return on equity for 2020 was: Return on Equity = Net Income/Shareholder’s Equity = 3.9% For 2021, the return on equity was 7.2%. One reason for the increased return on equity was the increase in net income. When analyzing the return on equity ratio, the business owner also has to take into consideration how much of the firm is financed using debt and how much of the firm is financed using equity.
Financial Ratio Analysis of XYZ Corporation
By looking at the quick ratio for both years, we can see that this company has to sell inventory in order to pay off short-term debt. The company does have short-term debt: accounts payable and notes payable, and we don’t know when the notes payable will come due. Let’s move on to the asset management ratios. We can see that the firm’s credit and collections policies might be a little restrictive by looking at the high receivable turnover and low average collection period. Customers must pay this company rapidly—perhaps too rapidly. There is nothing particularly remarkable about the inventory turnover ratio, but the fixed asset turnover ratio is remarkable. The fixed asset turnover ratio measures the company’s ability to generate sales from its fixed assets or plant and equipment. This ratio is very low for both 2020 and 2021. This means that XYZ has a lot of plant and equipment that is unproductive. It is not being used efficiently to generate sales for the company. In addition, the company has to service the plant and equipment, pay for breakdowns, and perhaps pay interest on loans to buy it through long-term debt. It seems that a very low fixed asset turnover ratio might be a major source of problems for XYZ. The company should sell some of this unproductive plant and equipment, keeping only what is absolutely necessary to produce their product. The low fixed asset turnover ratio is dragging down total asset turnover. If you follow this analysis on through, you will see that it is also substantially lowering this firm’s return on assets profitability ratio. With this firm, it is hard to analyze the company’s debt management ratios without industry data. We don’t know if XYZ is a manufacturing firm or a different type of firm. As a result, analyzing the debt-to-asset ratio is difficult. What we can see, however, is that the company is financed more with shareholder funds (equity) than it is with debt as the debt-to-asset ratio for both years is under 50% and dropping. This fact means that the return on equity profitability ratio will be lower than if the firm was financed more with debt than with equity. On the other hand, the risk of bankruptcy will also be lower. Unfortunately, you can see from the times interest earned ratio that the company does not have enough liquidity to be comfortable servicing its debt. The company’s costs are high and liquidity is low. Fortunately, the company’s net profit margin is increasing because their sales are increasing. Hopefully, this is a trend that will continue. Return on Assets is impacted negatively due to the low fixed asset turnover ratio and, to some extent, by the receivables ratios. Return on Equity is increasing from 2020 to 2021, which will make investors happy. As you can see, it is possible to do a cursory financial ratio analysis of a business firm with only 13 financial ratios, even though ratio analysis has inherent limitations.
