How to Use Common Business Ratios
What business ratios should you know and use? Here’s a breakdown of common ratios, how they’re used, and how you’ll calculate them.
Main ratios:
– Current: Measures a company’s ability to meet financial obligations. Expressed as the number of times current assets exceed current liabilities. A high ratio indicates that a company can pay its creditors. A number less than one indicates potential cash flow problems.
– Quick: This ratio is similar to the Acid Test (see below) and measures a company’s ability to meet current obligations using its most liquid assets. It shows Total Current Assets excluding Inventory divided by Total Current Liabilities.
– Total Debt to Total Assets: Percentage of Total Assets financed with debt.
– Pre-Tax Return on Net Worth: Indicates shareholders’ earnings before taxes for each dollar invested. This ratio is not applicable if the subject company’s net worth for the analyzed period has a negative value.
– Pre-Tax Return on Assets: Indicates profit as a percentage of Total Assets before taxes. Measures a company’s ability to manage and allocate resources.
Additional ratios:
– Net Profit Margin: Calculated by dividing Sales into the Net Profit, expressed as a percentage.
– Return on Equity: Calculated by dividing Net Profit by Net Worth, expressed as a percentage.
Activity ratios:
– Accounts Receivable Turnover: Calculated by dividing Sales on Credit by Accounts Receivable. This measures how well your business collects its debts.
– Collection Days: Calculated by multiplying Accounts Receivable by 360 and dividing by annual Sales on Credit. Generally, 30 days is exceptionally good, 60 days is bothersome, and 90 days or more is a real problem.
– Inventory Turnover: Calculated by dividing the Cost of Sales by the average Inventory balance.
– Accounts Payable Turnover: Measures how quickly the business pays its bills. It divides the total new Accounts Payable for the year by the average Accounts Payable balance.
– Payment Days: Calculated by multiplying the average Accounts Payable by 360, and dividing by new Accounts Payable.
– Total Asset Turnover: Calculated by dividing Sales by Total Assets.
Debt ratios:
– Debt to Net Worth: Calculated by dividing Total Liabilities by total Net Worth.
– Current Liab. to Liab.: Calculated by dividing Current Liabilities by Total Liabilities.
Liquidity ratios:
– Net Working Capital: Calculated by subtracting Current Liabilities from Current Assets. This is another measure of cash position.
– Interest Coverage: Calculated by dividing Profits Before Interest and Taxes by total Interest Expense.
Additional ratios:
– Assets to Sales: Calculated by dividing Assets by Sales.
– Current Debt/Total Assets: Calculated by dividing Current Liabilities by Total Assets.
– Acid Test: Calculated by dividing Current Assets (excluding Inventory and Accounts Receivable) by Current Liabilities.
– Sales/Net Worth: Calculated by dividing Total Sales by Net Worth.
– Dividend Payout: Calculated by dividing Dividends by Net Profit.
In the real world, financial profile information involves compromise. Very few organizations fit any one profile exactly. Variations, such as doing several types of business under one roof, are common. If you cannot find a classification that fits your business exactly, use the closest one and explain in your text how and why your business is different from the standard.
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