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It can help to answer critical questions such as whether the business is carrying excess debt or inventory, whether customers are paying according to terms, whether the operating expenses are too high and whether the company assets are being used properly to generate income. When computing financial relationships, a good indication of the company's financial strengths and weaknesses becomes clear. Examining these ratios over time provides some insight as to how effectively the business is being operated. Many industries compile average industry ratios each year. Average industry ratios offer the small business owner a means of comparing his or her company with others within the same industry. In this manner, they provide yet another measurement of an individual company's strengths or weaknesses. Robert Morris & Associates is a good source of comparative financial ratios. Following are the most critical ratios for most businesses, though there are others that may be computed. Note: There may be different ways to compute ratios. It is important to be consistent from year to year and use the same method when making comparisons. FisCAL calculates ratios the same way as Robert Morris Associates (RMA).
Liquidity measures a company's capacity to pay its debts as they come due. There are two ratios for evaluating liquidity. Current Ratio: The current ratio gauges how capable a business is in paying current liabilities by using current assets only. Current ratio is also called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or 2/1). However, an industry average may be a better standard than this rule of thumb. The actual quality and management of assets must also be considered. The formula is: Total Current Assets _____________________ Total Current Liabilities Quick Ratio: Quick ratio focuses on immediate liquidity (i.e., cash, accounts receivable, etc.) but specifically ignores inventory. Also called the acid test ratio, it indicates the extent to which you could pay current liabilities without relying on the sale of inventory. Quick assets are highly liquid and are immediately convertible to cash. A general rule of thumb states that the ratio should be 1 to 1 (or 1:1 or 1/1). The formula is:
Profitability Profitability ratios measure the company's ability to generate a return on its resources. It addresses three areas -..Cash + Accounts Receivable ( + any other quick assets ) _____________________ Current Liabilities 2. It quantifies the relationship between the capital invested by owners and investors and the funds provided by creditors. Gross Profit Margin: Gross profit margin indicates how well the company can generate a return at the gross profit level.inventory control. Debt to Equity: Debt to equity is also called debt to net worth. A lower ratio means your client's company is more financially stable and is probably in a better position to borrow now and in the future. It also can .g. Use the following four ratios to help your client answer the question. However. e. the degree of protection provided for the business' debt. "Is my company as profitable as it should be?" An increase in the ratios is viewed as a positive trend. It indicates how well the business has managed its operating expenses. The formula is: Gross Profit ____________ Total Sales Net Profit Margin: Net profit margin shows how much net profit is derived from every dollar of total sales. pricing and production efficiency. Three ratios help you evaluate safety. the greater the risk to a current or future creditor. Safety Safety indicates a company's vulnerability to risk. The higher the ratio. The formula is: Total Liabilities (or Debt) _____________________ Net Worth (or Total Equity) 3. an extremely low ratio may indicate that your client is too conservative and is not letting the business realize its potential.
Faster turnovers are generally viewed as a positive trend. It measures efficiency. As with accounts receivable turnover (above). they increase cash flow and reduce warehousing and other related costs. fewer days means the company is collecting more quickly on its accounts. The formula is: Net Profit Before Taxes _____________________ Total Assets 4. The formula is: . The formula is: 365 Days _____________________ Accounts Receivable Turnover Inventory Turnover: This ratio shows how many times in one accounting period the company turns over (sells) its inventory and is valuable for spotting under-stocking. You can use the following ratios: Collection Period: This reveals how many days it takes to collect all accounts receivable. obsolescence and the need for merchandising improvement. Besides determining the value of the company's assets. overstocking. The formula is: Net Profit _____________ Total Sales Return on Assets: This evaluates how effectively the company employs its assets to generate a return. Efficiency Efficiency evaluates how well the company manages its assets.indicate whether the business is generating enough sales volume to cover minimum fixed costs and still leave an acceptable profit. you and your client should also analyze how effectively the company employs its assets.
Cost of Goods Sold ________________ Inventory .