Managing Small Business Finances Ratios Classifications of Ratios

Managing Small Business Finances Ratios

“Classifications” of Ratios The different kinds of ratios are called by a number of names and this can become confusing until you understand what they exam. I use 4 classifications for financial ratios and they are as follows: • Liquidity Ratios • Profitability Ratios • Solvency Ratios • Activity Ratios

Liquidity Ratios Liquidity ratios are intended to measure a company’s ability to pay its short-term obligations. They test how “liquid” a company is by looking at its supply of cash or near-cash assets and comparing them with the expenses the company has to cover in the near future. The “bigger” the ratio the better the company’s ability to pay its short-term bills since the math for calculating the ratios has cash included in the numerator.

Liquidity Ratios • Current ratio: this measures the amount of current assets available to cover the amount of current liabilities that the company has to cover. It includes the cash on hand assets that could be easily converted to cash (if needed). • The current ratio is calculated as follows: Current Assets Current Liabilities

Liquidity Ratios • Accounts payable to Income Ratio. This ratio measures how quickly the company is paying its suppliers. If this result is higher than the industry benchmark, it might mean that the company is deliberately taking longer to pay its suppliers and therefore effectively using its suppliers to cover its operating expenses. This may indicate a problem. • This ratio is calculated as follows: Accounts Payable Annual Income

Liquidity Ratios • Quick Ratio: This is a more stringent version of the Current Ratio and it involves using the cash balance plus accounts receivable to get a picture of just the Liquid assets that are available to satisfy short-term debt and does not include assets that could be converted into cash. • This ratio is calculated as follows: Cash + Accounts Receivable Current Liabilities

Profitability Ratios Profitability ratios are a means of measuring how much profit a company can generate compared to the amount of expense it incurs to create those profits. Here also, having a number bigger than your competition means that you are out-performing them based on this measurement.

Profitability Ratios • Return on Assets: this is a very important ratio in that it indicates company profitability and how efficiently the company is using its assets. • This ratio is calculated as follows: Profit (either pre or post tax) Total Assets The higher the result, the better the company’s performance

Profitability Ratios • Profit margin: this is a calculation used to compare the company’s profit performance to its total sales. It is useful for comparison against competitors or against an industry benchmark. However it is important to emphasize that a profit margin in itself does not pay the expenses necessary to keep the business open and small business owners need to stay focused on cash flow. • Profit margin is calculated as follows: Net income Sales

Profitability Ratios • Return on Total Capital (Also called Return on Invested Capital) This is a measure of how effectively the company is allocating its capital for profitable investments. It is possible that a company could invest some of its capital in outside investments if it was determined that these outside investments would result in a greater return than investing internally. • This ratio is calculated as follows: After tax operating income Total debt + Owners Equity If this number is greater than the Weighted Average Cost of Capital, value is being created. If it is less, value is being destroyed.

Solvency Ratios Solvency ratios measure a company’s ability to pay its short-term and long-term obligations. They are important because they are actually measuring the all-important cash flow and not the company’s net income; two very different things. In order for these ratios to have real meaning the results need to be compared against an industry standard or companies in the same industry. This is because some industries are very debt-intensive and others are not, so a cross-industry comparison will have no relevance.

Solvency Ratios • Debt to Equity: Total Debt Total Shareholders Equity • Debt to Assets: Total Debt Total Assets • Debt to Capital: Total Debt + Total Shareholder’s Equity Debt, although a frequent necessity for many businesses, is not a good thing and these ratios are important because lower levels of solvency (the ability to satisfy loan repayments) increase the risk of default.

Activity Ratios Activity ratios measure how well a company’s management is doing in converting the goods it produces or the services it offers into cash. Time is an important aspect of these ratios since the longer it takes to leverage assets and convert them into cash creates a negative effect. A common example of an activity ratio is the Inventory Turnover ratio that is described on the next slide.

Activity Ratios • Inventory Turnover: this ratio represents the number of times in a given period (usually one year) that inventory had to be completely replaced. Low inventory turnover could indicate overproduction (possibly due to a flawed sales forecast) or a sudden change in market demand for the product or service. • The calculation for inventory turnover is: Cost of Goods Sold Ending Inventory

Activity Ratios • Days Sales calculation: closely related to inventory turnover, this ratio will show many days the company’s inventory is “on the shelf” (as a non-earning asset) before it is sold • Days Sales is calculated as follows: 365 Inventory Turnover

Activity Ratios • The next two ratios are also closely related • Receivables Turnover = Sales Accounts receivable • Days Sales in Receivables = 365 Receivables Turnover • The importance in calculating Days Sales in Receivables is that the result of that calculation (expressed in days) should align with the company’s credit policy. If it is higher than the policy, the company is negatively impacting its cash flow since it is waiting longer than planned to receive payments from its customers.

Activity Ratios • Fixed Asset Turnover: For most companies the greatest single category of expense that they will have to deal with is the investment in fixed assets, such as the building, the property it is located on and the equipment needed to produce their products. This calculation provides an approximate measure of how efficiently the company is using these assets to produce the products they sell. The calculation formula is as follows: Revenue Fixed Assets