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Financial Ratios and Quality Indicators Monitoring ratios on a regular basis provides insight into how effectively a business

is being managed. Investors/Lenders also evaluate risk by using several sets of ratios; ratios of assets to liabilities, and ratios of lender-investor dollars to owner-investor dollars. Recognize that ratios are only indicators and that only management can tell the full story about a business. The more adept management is at e plaining financial ratios to their Investors/Lenders, the better they will understand your business. !ey "ndicators with their definitions, formula and analysis comments are discussed in the following pages# $age % &i'uidity# (inancial ratios in this category measure the company)s capacity to pay its debts as they come due. *urrent Ratio +uick Ratio $age , -afety# (inancial ratios in this category are indicators of the businesses) vulnerability to risk. *reditors to determine the ability of the business to repay loans often use these ratios. .ebt To /'uity .ebt *overage Ratio $age 0 1 2 $rofitability# The ratios in this section measure the ability of the business to make a profit. -ales 3rowth *43- to -ales 3ross $rofit Margin -356 To -ales 7et $rofit Margin Return 4n /'uity Return 4n 6ssets $age 8 - 9 /fficiency# 6lso called 6sset Management ratios. "ndicator of how efficiently the company manages its assets. .ays "n Receivables 6ccounts Receivable Turnover .ays "n "nventory "nventory Turnover -ales To Total 6ssets .ays "n 6ccounts $ayable 6ccounts $ayable Turnover

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and as close to %#. Formula: Analysis: • "ndicates the e tent to which you could pay current liabilities without relying on the sale of inventory -. another way of e pressing li'uidity.LIQUIDITY (inancial ratios in this category measure the company)s capacity to pay its debts as they come due. current ratio means. Formula: Analysis: • • .. the +uick ratio still ignores timing of receipts and payments.#. but won)t be sold until the end of the month.== in current assets to cover each <.. a ratio of . &ook for a current ratio above . -pecifically e cludes inventory. (or e ample. *urrent 6ssets : *urrent &iabilities Quick Ratio Definition: The ratio between all assets 'uickly convertible into cash and all current liabilities. the company has <. as possible. 3enerally. the current ratio tells very little about the company)s ability to survive.#. >*ash ? 6ccounts Receivable@ : *urrent &iabilities • 2 .how 'uickly you can pay your bills.== in current liabilities. if all the bills are due this week. is good and indicates you don)t have to rely on the sale of inventory to pay the bills. 6lthough a little better than the *urrent ratio. and inventory is the only current asset. Current Ratio Definition: The ratio between all current assets and all current liabilities. 4ne problem with the current ratio is that it ignores timing of cash received and paid out.#.

This is particularly true for larger companies where shareholders want a higher reward >dividend rate@ than lenders >interest rate@. but too little debt may mean you are not realizing the full potential of your business -. (or this calculation it is common practice to include loans from owners in e'uity rather than in debt. . Debt to Equity Definition: -hows the ratio between capital invested by the owners and the funds provided by lenders.and may actually hurt your overall profitability. to 0#. talk to your accountant or financial advisor. *reditors to determine the ability of the business to repay loans often use these ratios... the greater the risk to a present or future creditor. Most lenders have credit guidelines and limits for the debt to e'uity ratio >%#. "f you think that you might be in this situation. Formula: Analysis: • *omparison of how much of the business was financed through debt and how much was financed through e'uity.#. The higher the ratio. is a commonly used limit for small business loans@. &ook for a debt to e'uity ratio in the range of .ebt 3 . Formula: Analysis: • • • -hows how much of your cash profits are available to repay debt.SAFETY (inancial ratios in this category are indicators of the businesses) vulnerability to risk. >7et $rofit ? 7on-cash e penses@ : . &enders look at this ratio to determine if there is ade'uate cash to make loan payments. Most lenders also have limits for the debt coverage ratio.ebt : /'uity • • • • Debt coverage ratio Definition: "ndicates how well your cash flow covers debt and the capacity of the business to take on additional debt. Too much debt can put your business at risk.

if not.&ast Aear)s sales@ : &ast Aear)s sales 7ote# substitute sales for a month or 'uarter for a shorter-term trend. Sales Growth Definition: $ercentage increase >or decrease@ in sales between two time periods. "f overall costs and inflation are on the rise. • &ook at the trend from month to month. Gross Profit Margin Definition: "ndicator of how much profit is earned on your products without consideration of selling and administration costs. then this is an indicator that your $rices are not keeping up with your costs..R!FITA"ILITY The ratios in this section measure the ability of the business to make a profit. "s it staying the sameC "mprovingC . COGS to Sales Definition: $ercentage of sales used to pay for e penses which vary directly with sales. Formula: >*urrent Aear)s sales . Analysis: • • &ook for a steady increase in sales.eterioratingC • "s there enough gross profit in the business to cover your operating costsC • "s there a positive gross margin on all your productsC 4 .. Formula: 3ross $rofit : Total -ales 3ross $rofit B -ales .*ost of 3oods -old Analysis: • *ompare to other businesses in the same industry to see if your business is operating as profitably as it should be. Formula: *ost of 3oods -old : -ales Analysis: • &ook for a stable ratio as an indicator that the company is controlling its gross margins. then you should watch for a related increase in your sales.

>This ratio is not very useful for most businesses.SG ! to Sales Definition: $ercentage of selling.@ Formula: 7et $rofit : Total 6ssets Analysis: • R46 shows the amount of income for every dollar tied up in assets. stock or bond. "s it staying the sameC "mprovingC . Formula: -elling. "et Profit Margin Definition: -hows how much profit comes from every dollar of sales. 5 . such as a savings account. • *ompare your ratio to other businesses in the same or similar industry. Return on !ssets Definition: *onsidered a measure of how effectively assets are used to generate a return. 6s an owner or shareholder this is one of the most important ratios as it shows the hard fact about the business -. Formula: 7et $rofit : Total -ales Analysis: • *ompare to other businesses in the same industry to see if your business is operating as profitably as it should be.. but watch out for changes in the total asset figure as you depreciate your assets >a decrease or increase in the denominator can affect the ratio and doesn)t necessarily mean the business is improving or declining. • Aear to year trends may be an indicator .etermines the rate of return on your investment in the business.are you making enough of a profit to compensate you for the risk of being in businessC Formula: 7et $rofit : /'uity Analysis: • *ompare the return on e'uity to other investment alternatives. general and administrative costs to sales.eterioratingC • 6re you generating enough sales to leave an acceptable profitC • Trend from month to month can show how well you are managing your operating or overhead costs. Return on Equity Definition: .. 3eneral 5 6dministrative / penses : -ales Analysis: • &ook for a steady or decreasing percentage indicating that the company is controlling its overhead e penses. • &ook at the trend from month to month.

$nventory #urnover Definition: 7umber of times that you turn over >or sell@ inventory during the year. 6 .8= days Analysis: • &ook for trends that indicate a change in your inventory levels. • Gut a high ratio can also mean there is a shortage of inventory. • 6 low turnover may indicate overstocking. • *ompare the calculated days in receivables to your stated terms. a high inventory turnover is an indicator of good inventory management. • *ompare to industry standards. or obsolete inventory.EFFI#IE$#Y 6lso called 6sset Management ratios. Days in Receivables Definition: This calculation shows the average number of days it takes to collect your accounts receivable >number of days of sales in receivables@. • Review an 6ging of Receivables and be familiar with your customerEs payment habits and watch for any changes that might indicate a problem.8= days Analysis: • &ook for trends that indicate a change in your customers) payment habits. • *ompare to industry standards. Formula: >6verage "nventory : *ost of 3oods -old@ D . the shorter the time between sales and collecting cash. Days in $nventory Definition: This calculation shows the average number of days it will take to sell your inventory >number of days sales F cost in inventory@. Formula: *ost of 3oods -old : 6verage "nventory Analysis: • 3enerally. Formula: 7et -ales : 6verage 6ccounts Receivable Analysis: • The higher the turnover. Formula: >6verage 6ccounts Receivable : -ales@ D . • *ompare to industry standards. !ccounts Receivable #urnover Definition: 7umber of times that trade receivables turnover during the year. "ndicator of how efficiently the company manages its assets. • *ompare the calculated days in inventory to your inventory cycle.

• *ompare to industry standards. the shorter the time between purchase and payment. Sales to #otal !ssets Definition: "ndicates how efficiently your business generates sales on each dollar of assets. Formula: -ales : Total 6ssets Analysis: • 6 volume indicator that can be used to measure efficiency of your business from year to year. Formula: *43. • 6 low turnover may indicate that there is a shortage of cash to pay your bills or some other reason for a delay in payment.• *ompare to industry standards.8= days Analysis: • &ook for trends that indicate a change in your payment habits. Days in !ccounts Payable Definition: This calculation shows the average length of time your trade payables are outstanding before they are paid. !ccounts Payable #urnover Definition: The number of times trade payables turnover during the year. Formula: >6verage 6ccounts $ayable : *43-@ D . • Review an 6ging of $ayables and be familiar with the terms offered by your suppliers. • *ompare the calculated days in payables to the terms offered by your suppliers. >number of days sales F cost in payables@.: 6verage 6ccounts $ayable Analysis: • The higher the turnover. 7 .