101: Ratios

By Gregg Schoenberg Tuesday, February 7, 2012

We recently concluded our Introduction to Financial Statements series that gave readers an overview of the three major financial statements: the balance sheet (Part I and Part II), the income statement (Part I and Part II), and the statement of cash flows (Part I and Part II). Throughout our discussion we used the statements to calculate some ratios, such as the current ratio and quick ratio in part two of the balance sheet post, that are useful in gauging the financial well being of a company.  Now let’s take a look at six more ratios that are easy to calculate and can offer more clues to the health of your business.  We’ll use the financial statements that we created for the fictitious ABC Corporation in our prior posts, so you may want to have those handy as we go through this lesson in ratio analysis.

The aforementioned quick and current ratios are the two most important liquidity ratios, as they give us information about a company’s liquidity position, which reflects its ability to pay off its debts in the near term.

The next category of ratios, the asset management ratios, tells us how well a business is managing its assets.  Let’s look at two of them.

Inventory Turnover Ratio = Total Revenue (also known as Net Sales) divided by Inventories.

In ABC’s case we have an inventory turnover ratio of $150,000/$10,000 = 15.  This means that each item that ABC stocks is sold and restocked, or turned over, 15 times a year.  The important thing to watch for here is how ABC’s turnover ratio compares with the average for firms in its industry (a firm selling fresh bread should obviously have a much higher turnover ratio than one selling custom-made electronics).  If your firm’s turnover ratio is much lower than the industry average, it is an indication that you are holding too much inventory, which can be a costly mistake.

Days Sales Outstanding (DSO) = Receivables divided by Average Sales Per Day.  (To calculate average sales per day we simply take total sales for the year and divide by 365.)

So ABC’s DSO is $13,000/($150,000/365) = 24.33 or roughly 24 days of sales outstanding.  The DSO tells us the amount of a time that a company must wait, on average, to receive its cash after making a sale.  In addition to comparing your DSO with an industry average, it is also helpful to see how it stacks up versus the payment terms that you have agreed to with your customers.  If ABC’s contracts call for payment within 30 days, then it is doing a good job of collecting the money it is owed during that window.  If, on the other hand, you find that your firm’s DSO is significantly higher than your payment terms, your business is being deprived of valuable cash and you may want to make more of an effort to collect your receivables on time.

Now, let’s take a look at two debt management ratios that can give us clues about a company’s ability to handle its debt load.

Debt Ratio = Total Liabilities divided by Total Assets and is expressed as a percentage.

ABC’s debt ratio is $38,000/$50,000 or 76% which means that its creditors have provided over three-quarters of its financing.  Once again, the industry average can serve as a good comparison point, but in general lenders prefer to see lower debt ratios as they indicate greater protection against losses.

Times Interest Earned (TIE) = EBIT divided by Interest Expense

ABC’s TIE ratio is $40,000/$5,000 = 8.  The TIE ratio tells us how many times over a firm’s annual interest expense is covered by its operating income.  As you would expect, a higher figure indicates a healthier company and one that is less likely to have trouble paying its debts.  If your firm’s TIE ratio declines steadily over time, or abruptly all at once, this should be cause for concern to both you and your lenders.

Finally, we want to examine two profitability ratios, which show us the combined effects of liquidity, asset management, and debt on a company’s bottom line.  As with the preceding ratios, comparing your firm’s profitability ratios to your peers will prove instructive.

Basic Earning Power (BEP) = EBIT/Total Assets (expressed as a percentage)

For ABC we have BEP of $40,000/$50,000 = 80%.  BEP shows us how well a firm is using its assets to generate earnings, so a higher percentage is preferable.  Keep an eye on how your firm’s BEP changes after you acquire new assets to see if those assets have increased or decreased your earning power.

Return on Common Equity (ROE) = Net Income divided by Common Equity

ROE is one of the most, if not the most, important of the financial ratios as it tells us how well investors in a business are doing on their investment.  ABC’s ROE comes in at $23,000/$12,000 = 192% (note that this is higher than anything you are likely to see in the real world, an ROE somewhere in the 10-30% range is more normal, but ABC has the good fortune to operate in the fictitious world).  A higher ROE indicates that a company is delivering its owners a higher return on their investment and that, of course, is what all investors want to see.

If you take the time to understand and track all of these ratios for your company, you will find that your financial statements offer a wealth of valuable and easy-to-calculate information that can help you run your business more smoothly.

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