RATIO ANALYSIS

Ratios provide very useful tools for the manager to assess the organization by making
two basic types of comparisons. First, the analyst can compare a present ratio with past
(or expected ) ratios for the organization to determine if there has been an improvement
or deterioration or no change over time. Second, the ratios of one organization may be
compared with similar organizations or with industry averages at the same point in time
making sure that "apples are compared with apples and oranges with oranges." This is a
type of "benchmarking" so that one may determine whether the organization is "average"
in performance or doing better or worse than o

FINANCIAL RATIOS

Perhaps the most commonly used ratios in business are financial ratios. These are
developed by use of the income statement and the balance sheet. No one ratio will give
sufficient information to judge the financial condition and performance of the firm.
Financial ratios cover four areas of concern as follows:

Liquidity --the ability to have Debt (Leverage)-- reveal the

cash ready when needed and relationship of your sources of
these include capital such as
Current Ratio
Quick (Acid-test) Ratio Debt to Equity
Liquidity of Receivables Debt to Assets
Average collection period Debt to Net Worth
Receivables turnover
Aging of Accounts Payable
Inventory Turnover

The liquidity and leverage (debt) ratios represent as assessment of the risk of the
company. Activity (profitability) ratios are measures of the return generated by the assets
of the company.

Profitability (Activity) -- measure profit Coverage -- indicate ability to pay

in relation to sales, assets, or some other your debts given the amount of
base as indicators of efficiency such as money coming in such as

Profitability to Sales Times Interest Earned

Gross Profit Margin Cash Flow to Debt Maturities
Net Profit Margin Doomsday Ratio
Profitability to Investment
Rate of Return on Equity
Return on Assets
Turnover Ratio

Liquidity Ratios:
Current Ratio

This ratio is a measure of the ability of a firm to meet its short-term obligations. It is
perhaps the best known measure of financial strength at a given point in time. In general,
a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that some potential
difficulty in covering obligations may exist. A high ratio may indicate that the firm has
too may assets tied up in current assets and is not making efficient use to them.

Current Ratio = Current Assets

Current Liabilities

Quick (Acid-Test) Ratio

The Quick (or Acid-Test) Ratio is the same as the current ratio except that it excludes
inventories from the current assets. Inventories are usually the least liquid portion of the
current assets and may be difficult to dispose of -- especially if they are slow-moving
and/or become obsolete. A typical quick or acid-test ratio would be about 1.0 for
American industries. However, this ratio must be used with caution as certain industries
may carry a great deal of inventory and others very little so this should be compared to
others in the same business.

Quick Ratio = Current Assets - Inventories

Current Liabilities

Average Collection Period

This ratio simply indicates how long the average account is outstanding in days. It
measures how efficiently you collect money due you from your customers. If this
indicates that payments are taking a long time to collect, then collection/billing
procedures should be reviewed. On the other hand, too short a period could cause
customers to move to another supplier that has more reasonable collection policies.

Average Collection Period = Receivables x Days in Year

Annual Credit Sales

The "days in year" would be 365 if your company is open all the time. More frequently, it
is less.

Average Receivables Turnover

This ratio simply indicates how may times a year the accounts turn over. Please note this
ratio is the inverse of the average collection period. Some organizations will prefer this
ratio, others will prefer using the previous one.

Average Receivables Turnover = Annual Credit Sales

Receivables

Inventory Turnover
This widely used ratio tells you how fast your inventory is moving. It is an indicator of
the liquidity of inventory, since it tells the rapidity with which the inventory is turned
over into receivables through sales. The norm for American industries is about 9 but this
will vary from industry to industry. The higher the ratio, the more efficient the inventory
management of the firm, but too high a ratio could indicate a level of inventory that is too
low with resulting frequent stockouts and the potential of losing customers. It could also
indicate inadequate production levels to meet customer demand. Caution must be used
with this ratio (as with all of the others) since ratios reveal hidden meaning and must be
interpreted correctly. A ratio by itself will never give an answer! The preferred way to
calculate this ratio is

Inventory Turnover = Cost of Good Sold

Average Inventory

Note: Average Inventory = (beginning inventory + ending inventory) / 2

Debt (Leverage) Ratios:

Debt to Net Worth

This ratio indicates the percentage of total funds provided by debt. A ratio higher than 0.5
is usually considered safe only in stable industries. This ratio is usually shown as a
percentage by simply multiplying the ratio by 100.

Debt to Net Worth = Debt X 100

Total Funds

Debt to Equity

This ratio tells the extent to which long-term financing has been provided by creditors. In
other words, it compares the total of what is owed (debt) to what is owned (stockholders
equity) so that a ratio above 100% would indicate the capital provided by lenders to your
business exceeds that provided by the stockholders. Owners would like a high ratio,
because for every dollar they invested in the company they can buy more assets that
would support higher levels of sales and a higher return on their investment. This is
leverage -- but it also increases risk! Conversely, lenders would want a low ratio to insure
that the loan made to the company may be repaid with ease. Median values for this ratio
vary from about 30% to more than 150%. Due to this wide variation, it is important to
compare with other companies in the same industry.

Debt to Equity = Total liabilities X 100

Stockholders Equity
Debt to Assets

This ratio is often called the debt ratio since it compares what is owed to the value of the
assets used by the organization. This monitors use of debt used to build your business. It
tells what percentage of your firm's assets are financed by borrowing. A firm reporting a
debt ratio greater that 100% is functionally bankrupt. As long as some equity exists, this
ratio has to be less that 100%. What may be considered an "acceptable" debt ratio
changes from time to time as well as from industry to industry so be very careful in using
this ratio.

Debt to Assets = Total Liabilities x 100

Total Assets

Profitability (Activity) Ratios:

Gross Profit Margin

This shows the average amount of profit considering only sales and the cost of the items
sold. This tells how much profit the product or service is making without overhead
considerations. As such, it indicates the efficiency of operations as well as how products
are priced. Wide variations occur from industry to industry. For example, movie theater
concessions may exceed 90% while retail grocery margins may only be a few percentage
points.

Gross Profit Margin = Sales - Cost of Goods Sold x 100

Net Sales

Net Profit Margin (Return on Sales)

This ratio indicates the relative efficiency of the firm after taking into account all
expenses and income taxes, but not extraordinary charges. It is a widely reported figure.
There is a wide variation in the United States but the average is about 5 - 6 percent.

Profit Margin = Net Profit (after taxes) X 100

Net Sales

Rate of Return on Equity (ROE)

This ratio is calculated by dividing the net profit after taxes (net earnings) by the net
worth (stockholders' equity). This shows the earning power on shareholders' book
investment and is often used to compare two or more firms in the same industry. The
figure for net worth may also use the market value of the stock and thus indicates the
return on market value of the stock. This ratio indicates how much your company is
making on the money that was invested in the firm and hints to investors how efficiently
your operations are and how well the firm is being managed. This ratio typically averages
between 5 - 25% with 10% being considered desirable.
 Return on Equity = ROE = Net Earnings x 100
Net Worth

or ROE = Net Earnings x 100

Stock Market Value

Return on Assets (ROA)

This ratio is one of the most widely used (and misused) in the analysis of profitability
since it indicates how efficiently the assets are being used. Since it measures the earning
power of your assets, many argue that it is the best overall measurement of efficiency.
However, numerous problems with this ratio have developed in actual use including
motivating managers to look to the short-term rather than investing for the long-term.
Can you figure out how this might happen? This measure is also called the return on
investment (ROI).

Return on Assets = ROA = Net Earnings x 100 Total Assets

Turnover Ratio

This ratio tells us the relative efficiency with which the firm utilizes its resources in order
to generate output.

Turnover Ratio = Sales

Total Assets

Coverage Ratios (all relate the financial charges of a

company to its ability to service them):
Times Interest Earned

This ratio measures the ability of the firm to pay the interest due on their loans. Lenders
want to see a cushion of safety between what is due and what is available to cover the
debt in case sales and/or earnings decline some time in the future. Then the ratio exceeds
10 you will probably receive a favorable review from lending institutions. Below a 4 or 5,
warning signals should go off!

T I E = Net Profit (before taxes) + Interest Expense

Interest Expense

Cash Flow to Debt Maturities

This will tell if you can meet your annual debt payments from the cash generated by the
business. A value of 2 or more will satisfy most lenders since you are generating twice as
much money as needed to cover the principal payments on your loans.

C F to D M = Net Profit (after taxes) + Depreciation Expense

Long Term Debt Maturities

Doomsday Ratio

This is related to the quick (acid test) ratio since it is a conservative approach to debt
coverage. This ratio only considers the cash on hand when evaluating if you can cover
your current liabilities. It takes the approach that if the business went under today, would
you have enough on hand to cover these current debts. This is a good indicator of your
cash cushion of safety. It could help spot cash shortages and help avoid a credit crisis.

Doomsday Ratio = Cash

Current Liabilities