Managers use financial ratios to analyze business performance.
The balance sheet and income statement of a business form the basis for financial analysis and planning. The calculation of various ratios provides insight into the strengths and weaknesses of a company and identifies areas that need improvement. Understanding interpret and use these ratios is a critical skill for all managers. Financial ratios fall into four main categories: profitability, liquidity, activity and debt leverage.
Profitability
Managers use net and gross profit to gauge the profit performance of the company. Net profit is calculated by dividing the dollar amount of net profits by total sales and multiplying by 100. This produces a percentage that can be compared to previous years and other companies in the same industry.
Gross profit measures the profit of a business before deducting overhead expenses. Gross profit is total sales minus cost of goods sold --- labor, materials, shipping costs and supplies.
Liquidity
While making a profit is important, having enough liquidity to meet debt obligations on a timely basis is even more important. Two ratios provide gauges of liquidity: current ratio and quick ratio.
The current ratio is found by dividing current assets --- cash, accounts receivable and inventory --- by current liabilities. Most businesses need a current ratio of at least 2:1 to have a comfortable level of liquidity.
The quick ratio provides a harsher measure of liquidity. It is calculated by dividing the sum of cash plus accounts receivable by current liabilities; it excludes inventory from the calculation. A quick ratio less than 1.5:1 would signal potential liquidity problems.
Activity Ratios
Activity ratios focus on specific areas of a business. Two examples are the accounts receivable turnover ratio and the inventory turnover ratio.
Accounts receivable turnover is calculated by dividing total annual credit sales by the average accounts receivable balance. As an example, if a company sells on 30-day terms to its customers and the turnover ratio is exactly 12, then all of the receivables are being collected on time. If a manager sees this ratio drop below 12, he knows that customers are paying more slowly, and he must increase the collection efforts.
Inventory turnover is determined by dividing annual cost of goods sold by the average inventory balance. Companies do not like to maintain high levels of inventory since this ties up funds for longer periods of time. A manager will try to minimize the amount of goods in inventory and increase the inventory turnover ratio.
Debt Leverage
Bankers and analysts consider a company with more shareholders' equity than debt as better capitalized and financially stronger. They will analyze the debt-to-equity ratio to determine the financial strength of a business. Most bankers prefer a debt-to-equity ratio less than 2:1.
If a company wants to expand by purchasing additional equipment and fixed assets and already has a high debt-to-equity ratio, it will be forced to seek more shareholder capital.
