In a previous article of mine, the basics of budgeting and financial analysis were outlined. For anyone wanting more complex ways to evaluate how a business is doing, there are several formulas that can be used. These ratios measure liquidity, leverage, operations and performance.
Liquidity, the ability to meet short term obligations, is an important aspect of a company’s financial well being. Liquidity also refers to the capability to convert assets and receivables into cash. There are two basic formulas that can measure liquidity. The current ratio is obtained by taking the current assets and dividing that number by current liabilities. A ratio of 2.0 or higher is favorable. The quick ratio measures how assets can be used to meet debts. Subtract the inventory from current assets, and then divide by current liabilities. Ideally, this number should be above 1.0.
Leverage ratios basically measure how much financing comes from creditors and owners. The debt ratio determines how much financing is furnished by creditors. Divide total liabilities by total assets to obtain this figure. A debt ratio of 1.0 means all assets have been financed by debt. The debt-to-equity ratio compares what is owned to what is owed. For this figure, total liabilities are divided by owners equity, or net worth. A debt-to-equity ratio of less than 1.0 is ideal, meaning a company owns more than it owes.
Operating ratios measure earning power and how effectively a company uses resources. An accounts receivable ratio measures the collectablility of funds owed by customers (advertising sales). Divide the credit sales by the average accounts receivable figure to obtain this ratio. This ratio is used often, because an uncollectible accounts receivable is not of any use to an investor. The collection period ratio shows the average length of time for accounts receivable to be paid. In this case, the lower the number, the better. To figure this ratio, take the accounts receivable and multiply by 365, then divide by annual credit sales. Or you can take 365 and divide by the number you obtained when figuring the accounts receivable ratio.
Finally, performance ratios measure how successful a business is at making money. The return on assets ratio (ROA) is widely used. It indicates a manager’s ability to generate profit – simply divide the net income or net profit by average total assets. The return on equity ratio measures return on an owners’ investment. This formula is net profit (usually after tax) divided by owners equity.
The average person probably won’t need these ratios when trying to determine how well a business is doing. But if you are looking to invest, or perhaps audit your own business, these figures can be helpful. When figuring these ratios, having the balance sheets handy will make things a lot easier and quicker. (The info you need to compute the ratios is found on the balance sheets.) There are other ratios, and some people or institutions may have different ways of computing them, but if you want to know the basics of a business these can be helpful.