UNDERSTANDING FINANCIAL AND OPERATING RATIOS

31 OPERATING and FINANCIAL RATIOS

How each ratio is calculated and what each ratio means to your business.

Operating and financial ratios are used to identify warning signs before they become costly problems.
Ratios can help management take corrective action to prevent potential future problems.

What is important here is that management understands how each ratio is calculated and what each ratio actually means to the company's performance sales, productivity or profit.

The analysis of ratios can, and will, prevent most business failures.

The analysis of ratios can, and will, help you maximize your company's sales, productivity and profit potential.

For most ratios, all you need is access to a balance sheet and an operating statement.

Some ratios are more important than others, depending on your industry. Most companies have about 9 to 15 ratios worth monitoring.

Usually ratios are monitored from quarter to quarter and from year to year.
The actual number, value, or percent of the ratio is not as important as the trend of the ratio, indicating the direction a company is going.

Each ratio should be tracked for about four years and the overall trend (up or down) analyzed.

1. OPERATING EXPENSES TO NET SALES:

Divide operating expenses into net sales (use the percent key on your calculator).

This ratio is a measure of management efficiency and general effectiveness in controlling operating expenses (does not include direct cost of sales). We are looking for a constant (minimum management performance) but prefer a declining ratio,


2, OPERATING EXPENSES TO FIXED ASSETS:

Divide operating expenses into fixed assets.

This is a measure of management efficiency and effectiveness in maximizing the utility of the facility (plant, equipment, machinery). The trend should go up, a downtrend generally indicates lax control of fixed assets acquisition.


3, OPERATING EXPENSES TO WORKING CAPITAL:

Divide operating expenses into working capital.

This ratio measures the cash cycle or the use of the working capital. Too low a cycle indicates too much working capital and it is not working hard enough (idle capital cost money), Too high a cycle indicates a shortage of working capital and possible cash flow problems.

4. CURRENT ASSET TURNOVER:

Divide current assets into total sales.

This measures a company's ability to efficiently utilize its current investment in the generation of sales. Too higher ratio indicates inadequate level of activity, while too low a ratio indicates sluggish use of available resources.


5. TOTAL ASSET TURNOVER:

Divide total assets into total sales.

Upper quartile performers generally show higher turnover rates. This, combined with higher profit as percentage of sales results in higher return on investment,


6. NET SALES TO WORKING CAPITAL:

Divide net sales into net working capital.

This provides a guide as to the extent the business is turning its working capital and the margin of operating funds.


7. NET SALES TO FIXED ASSETS:

Divide total net sales into fixed assets.

This ratio has a ceiling (above ceiling indicating insufficient facilities for the sales activities) and also has a floor (below floor indicating insufficient sales activity for available facilities). Management's task is to balance the resources and sales in order to maximize its return on its resources.


8. NET SALES TO NET WORTH:

Divide net sales into net worth (the stockholders equity).

This is a measure of relative turnover of invested capital.


9. TIMES INTEREST EARNED:

Divide the interest payments into net profit.

This ratio indicates how readily a company can pay its fixed interest charges and if its borrowed funds have been put to good use so that the earnings are sufficient to pay the interest cost.


10. AVERAGE COLLECTION PERIOD:

Average daily credit sales are divided into accounts receivable.

This ratio analyzes the colectability of receivables. The collection period should not exceed the
sales terms by 10 days (net 30 days= 40 days average collection period).


11. WORKING CAPITAL:

Deduct all current liabilities from all current assets.

The amount left is a company's working capital. The ability to meet its financial obligations and increase sales depends on the availability of working capital,


12.WORKING CAPITAL REQUIRED:

The determination of this value requires the following information:

A) The amount of time required collecting accounts receivable.

B) The amount of time required to process inventories into finished goods.

C) The amount of payments required of accounts payable.

D) Other elements of the current assets and current liabilities.

Working capital requirements depend on each company's individual financial conditions and requirements.


13. NET WORTH:

Deduct all assets from all liabilities.

This represents the gross amount the company owes the stockholders. This amount also represents the value of the company (book value only, not real value which is almost always substantially higher) in the event of liquidation.


14. COMMON EQUITY:

Total net worth less the value of the preferred stock and any value of intangible assets.

This ratio represents the portion of net worth that relates only to the common stock investment.


15. NET PROFIT AFTER TAXES:

Divide net profit, after taxes, into sales (use the percent key of your calculator).

This important yardstick is measuring a company's profitability.


16. RETURN ON INVESTMENT:

Total net profit, before taxes, divided into total assets (use the percent key of your calculator).

This ratio measures the income produced by the company's assets. This is a true measure of profitability (ROI).


17. RETURN ON NET WORTH:

Total profit divided by shareholders equity (use the percent key of your calculator).

This is a measure of profitability of the assets financed by shareholders equity.


18. NET PROFIT TO NET WORTH:

Total net profit divided by total net worth (use the percent key of your calculator).

This ratio indicates the effectiveness of management in producing operating profits relative to stockholder equity.


19. NET PROFIT TO WORKING CAPITAL:

Divide net profit into working capital (use the percent key of your calculator).

This ratio indicates the cushion available to the company for carrying inventories and receivables and for financing day-today operations.


20. NET PROFIT TO TOTAL ASSETS:

Divide total profit into total asset (use the percent key of your calculator).

This ratio provides continuous information for updating the fixed assets and improving the return on investment and insuring against obsolescence.


21.NET PROFIT TO DEBT:

Divide long-term debts into operating profits (use the percent key of your calculator).

A high return is not always indicative of a good performance; it could be the result of under capitalization, which could make a company vulnerable if there is a decline in profit.


22. ACCOUNTS PAYABLE TO INVENTORY:

Divide the accounts payable into inventory.

This ratio indicates the extend to which the company relies on funds from the disposal of inventories to meet its obligations.


23. MATERIAL TURNOVER:

Divide the cost of goods sold into the average inventory.

Low rates may indicate an over stocked condition and high rates may indicate low stock, which could be due to cash flow problems or inability to secure credit from suppliers.


24. CASH FLOW:

Net operating profit, before taxes, plus depreciation allowance for the period analyzed.

Cash flow is the amount of funds available to the company for expansion and acquisition.


25. NET INCOME AFTER TAX:

This is the net income after tax liabilities.

This number will be transferred to the balance sheet and added to the company's retained earnings in the stockholders equity accumulation accounts.


26. CURRENT ASSET TO TOTAL ASSET:

Divide current asset into total asset.

This ratio indicates the relative proportion of the current asset to the total asset. A low ratio indicates a potential cash flow problem.


27. CURRENT ASSET TO CURRENT LIABILITY:

Divide all current assets into current liabilities.

This is a principal test of solvency and determines a company's ability to meet its financial obligations.


28. QUICK RATIO (ACID TEST):

Divide current assets (minus inventory) into current liabilities.

This test of solvency is often used by banks to determine a company's ability to pay back loans. A
low ratio could be a problem, however inventory turns must be taken into consideration (high inventory turns could balance a low quick ratio).


29. CASH TO ASSET:

Divide total cash into total assets.

This ratio identifies the proportion of cash to total assets. The trend direction is important in analyzing the dynamics of cash availability as related to a company's demand for cash.


30. WORKING CAPITAL TO TOTAL ASSETS:

Working capital divided into total assets.

This ratio identifies the part of the total investment that is available to the company for growth, acquisitions and expansions.


31. INVENTORY TURNOVER:

Divide total sales (annual) into inventory from the balance sheet.

Even though this ratio does not provide an accurate inventory turn it is a good yardstick to measure inventory turns form one period to another.



UNDERSTANDING FINANCIAL AND OPERATING RATIOS - To learn more about this author, visit MIchael Otto's Website.

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