Financial Ratios: Explanations

October 19, 2015 by Jarred Berman

INTRODUCTION TO FINANCIAL RATIOS

A sustainable business and mission requires effective planning and financial management. Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact.

For ratios to be useful and meaningful, they must be:

• Calculated using reliable, accurate financial information (does your financial information reflect your true cost picture?)
• Calculated consistently from period to period
• Used in comparison to internal benchmarks and goals
• Used in comparison to other companies in your industry
• Viewed both at a single point in time and as an indication of broad trends and issues over time
• Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance.

Ratios can be divided into four major categories:

• Liquidity
• Coverage/Leverage
• Profitability Sustainability
• Operational Efficiency

LIQUIDITY RATIOS

Does your enterprise have enough cash on an ongoing basis to meet its operational obligations? This is an important indication of financial health.

Ratio	Formula	Description
Current Ratio	Current Assets Current Liabilities	Measures your ability to meet short term obligations with short term assets. A useful indicator of cash flow in the near future.   A ratio less that 1 may indicate liquidity issues. A very high current ratio may mean there is excess cash that should possibly be invested elsewhere in the business or that there is too much inventory. Most believe that a ratio between 1.2 and 2.0 is sufficient.   The one problem with the current ratio is that it does not take into account the timing of cash flows. For example, you may have to pay most of your short term obligations in the next week though inventory on hand will not be sold for another three weeks or account receivable collections are slow.
Quick Ratio (aka Acid Test Ratio	Cash + A/R + Marketable Securities Current Liabilities	A more stringent liquidity test that indicates if a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. Looks at the company’s most liquid assets only (excludes inventory) that can be quickly converted to cash. A ratio of 1:1 means that a social enterprise can pay its bills without having to sell inventory.
Working Capital	Current Assets – Current Liabilities	Working capital is a measure of cash flow and should always be a positive number. It measures the amount of capital invested in resources that are subject to quick turnover. Lenders often use this number to evaluate your ability to weather hard times. Many lenders will require that a certain level of working capital be maintained.

COVERAGE/LEVERAGE RATIOS

To what degree does an enterprise utilize borrowed money and what is its level of risk? Lenders often use this information to determine a business’s ability to repay debt.

Ratio	Formula	Description
Debt to Equity	ST Debt + LT Debt Total Equity	Compares capital invested by owners/funders (including grants) and funds provided by lenders. Lenders have priority over equity investors on an enterprise’s assets. Lenders want to see that there is some cushion to draw upon in case of financial difficulty. The more equity there is, the more likely a lender will be repaid. Most lenders impose limits on the debt/equity ratio, commonly 2:1 for small business loans. Too much debt can put your business at risk, but too little debt may limit your potential. Owners want to get some leverage on their investment to boost profits. This has to be balanced with the ability to service debt.
Interest Coverage	EBIT Interest Expense	Measures your ability to meet interest payment obligations with business income. Ratios close to 1 indicates company having difficulty generating enough cash flow to pay interest on its debt. Ideally, a ratio should be over 1.5.

 

PROFITABILITY SUSTAINABILITY RATIOS

How well is our business performing over a specific period, will your social enterprise have the financial resources to continue serving its constituents tomorrow as well as today?

 

Ratio	Formula	Description
Sales Growth	Current Period – Prior Period Sales Prior Period Sales	Percentage increase (decrease) in sales between two time periods.
Operating Self-Sufficiency	Business Revenue Total Expenses	Measures the degree to which the organization’s expenses are covered by its core business and is able to function independent of external support. For the purpose of this calculation, business revenue should exclude any non-operating revenues or contributions. Total expenses should include all expenses (operating and non-operating) including social costs. A ratio of 1 means you do not depend on external revenue or other funding.
Gross Profit Margin	Gross Profit Total Sales	How much profit is earned on your products without considering indirect costs. Is your gross profit margin improving? Small changes in gross margin can significantly affect profitability. Is there enough gross profit to cover your indirect costs. Is there a positive gross margin on all products?
Net Profit Margin	Net Profit Total Sales	How much money are you making per every $ of sales. This ratio measures your ability to cover all operating costs including indirect costs.
SGA to Sales	Indirect Costs (Sales, General, Admin) Total Sales	Percentage of indirect costs to sales. Look for a steady or decreasing ratio which means you are controlling overhead.
Ratio	Formula	Description
Return on Assets	Net Profit Average Assets	Measures your ability to turn assets into profit. This is a very useful measure of comparison within an industry. A low ratio compared to industry may mean that your competitors have found a way to operate more efficiently. After tax interest expense can be added back to numerator since ROA measures profitability on all assets whether or not they are financed by equity or debt.
Return on Equity	Net Profit Average Shareholders’ Equity	Rate of return on investment by shareholders. This is one of the most important ratios to investors. Are you making enough profit to compensate for the risk of being in business? How does this return compare to less risky investments like bonds?

 

OPERATIONAL EFFICIENCY RATIOS

How efficiently are you utilizing your assets and managing your liabilities? These ratios are used to compare performance over multiple periods.

 

Ratio	Formula	Description
Operating Expense Ratio	Operating Expenses Total Revenue	Compares expenses to revenue. A decreasing ratio is considered desirable since it generally indicates increased efficiency.
A/R Turn	Net Sales Average A/R	Number of times trade receivables turnover during the year. The higher the turnover, the shorter the time between sales and collecting cash.   This is good. This ratio is only useful if majority of sales are credit (not cash) sales.
Days in A/R	Average A/R (Credit Sales x 365 days/yr)	This ratios tells you the average number of days it takes to collect an account receivable. Since the days’ sales in accounts receivable is an average, you need to be careful when using it.
Inventory Turn	COGS Average Inventory	The number of times you turn inventory over into sales during the year or how many days it takes to sell inventory. This is a good indication of production and purchasing efficiency. A high ratio indicates inventory is selling quickly and that little unused inventory is being stored (or could also mean inventory shortage). If the ratio is low, it suggests overstocking, obsolete inventory or selling issues.
Days in Inventory	Average Invetory (COGS x 365 days/yr)	This ratio is a financial measure of a company’s performance that gives investors an idea of how long it takes a company to turn its inventory into sales. Generally, a lower ratio is preferred, but it is important to note that the average varies from one industry to another.
Ratio	Formula	Description
A/P Turn	COGS Average A/P	The number of times trade payables turn over during the year. The higher the turnover, the shorter the period between purchases and payment. A high turnover may indicate an unfavorable supplier repayment terms. A low turnover may be a sign of cash flow problems.
Days in A/P	Average A/P (COGS x 365 days/yr)	Compare your days in accounts payable to supplier terms of repayment. (If necessary).
Asset Turn	Revenue Average Total Assets	How efficiently your business generates sales on each dollar of assets. An increasing ratio indicates you are using your assets more productively.
Fixed Asset Turn	Revenue Average Fixed Assets	How efficiently your business generates sales on each dollar of assets. An increasing ratio indicates you are using your assets more productively.