Calculating Crucial Financial Ratios
The idea of calculating financial ratios can seem intimidating, but it's really much easier than it sounds. A ratio is really just a fraction, expressed in a slightly different way to let you see how two numbers compare to one another. You actually use ratios every day. For instance, if it takes you two hours to drive 120 miles, you know that you've driven 60 miles per hour, a ratio you calculated by dividing 120 miles by two hours. If that drive uses up ten gallons of gas, you know that your car gets twelve miles per gallon, a ratio computed by dividing 120 miles by ten gallons.
Are financial ratios required to make a complete set of financial statements?
No, a full set of financial statements doesn't have to include ratio analysis. However, there are times when you need to know particular ratios. For example, if you have a business loan, the bank may require your company to meet specific ratio minimums.
Financial statement ratios really aren't much different: they take some figures off the financial statements and compare them. The meaningful analysis comes with the particular numbers you use to compute these ratios and with what the results indicate. The three main categories of analysis are profitability, liquidity, and debt and investment.
A full ratio analysis can tell you a lot about the financial health of your company. Some ratios will let you know how well you're managing cash. Others tell you if your company is in a position to take on more debt. Still others provide an objective measure of your profitability. By looking at the ratio results, both individually and collectively, you'll understand your company's finances in a completely different (and more comprehensive) way.
Business owners want to know about profits, which makes this group of ratios the most commonly used (at least voluntarily) among entrepreneurs. As the name indicates, profitability ratios measure how profitable your company is at different stages. You calculate gross profit margin, operating profit margin, and net profit margin (whenever applicable). By taking this measure from different points on your statement of profit and loss, you can see clearly where your revenues are going and whether any expense types are eating up a disproportionate share of the income.
Interest and income taxes are held out separately from operating expenses because they aren't really part of your operations. Interest expense is typically temporary, linked to a particular business loan, and therefore doesn't count as an ongoing operating expense. Income tax expense (only an issue for corporations) comes after the fact and exists only when there are profits to tax.
Your company's gross profit lets you know how much of your company's sales dollars are left over after you've paid for the goods you sold. The operating profit tells you how much is left after cost of goods and operating expenses are deducted from your revenues (those expenses don't include income taxes and interest). For service businesses, the gross profit and operating profit are the same, for they don't have any cost of goods to deal with. Finally, the net profit shows how much is left of your sales dollars after you deduct absolutely everything: costs, expenses, interest, and income taxes.
To calculate these ratios, you simply pull the applicable profit from your statement and divide it by your net sales. Gross profit margin equals your gross profit divided by total net sales. Operating profit margin equals your income from operations divided by total net sales. Net profit margin equals your bottom-line net profit divided by total net sales. When your company doesn't have any interest or income tax expense, the net profit margin is the same as the operating profit margin.
With all profitability ratios, higher numbers are better numbers. Remember, though, that what's considered good or normal for one industry could be considered paltry for another. Service businesses, for example, will naturally have much higher operating margins than do product businesses. Product industries with high markup (such as clothing) will have higher gross margins than those with lower markup (such as hardware). Don't look at your margins without some kind of industry reference to put them in perspective.
Liquidity ratios measure your company's ability to pay its bills — in accounting terms, to meet financial obligations. While it's important to be able to pay all the bills, the current liabilities are more critical, especially for a new small business. Your current liabilities cover the things you need to run your business every day: inventory, supplies, power. If you can't pay these vendors, they may stop providing goods and services, and your company wouldn't be able to function.
Your quick ratio can never be greater than your current ratio; if it comes out that way, recalculate both. Your total current assets can't be less than your total current assets minus inventory; that's why the current ratio has to be greater.
The two most important liquidity measures are the current ratio and the quick ratio. The current ratio spells out in no uncertain terms whether your company will be able to meet its immediate financial obligations. It literally calculates how many dollars of current assets you have on hand to pay down your current liabilities. To compute the current ratio, divide your total current assets by your total current liabilities (you can find these numbers on your balance sheet).
The quick ratio takes the current ratio up one more notch. Here you don't include inventory in the numerator, even though it's a current asset. The logic behind this acknowledges that inventory is the toughest current asset to get rid of fast; it's the one that will take the longest to convert into cash. Since you can't pay your bills with inventory, product-based companies can get a better liquidity picture using the quick ratio. To compute the quick ratio, first subtract the inventory from the total current liabilities; then divide that result by the total current liabilities to get the quick ratio. If your company doesn't sell any products, compute only the current ratio.
Debt and Investment Ratios
Most new businesses need to borrow money to get started. One very common problem is taking on too much debt too soon, as they try to grow at lightning pace; the more in debt a company is, the harder it is for that company to succeed. Also, when debt is disproportionately high, it cuts too deeply into the company's profits, and that means you're getting a smaller return on your investment in the company. By looking at debt and investment ratios, you can better gauge your company's debt position and learn whether you're earning a reasonable return on your investment.
You can find out what is an acceptable debt ratio for your company from your banker or your main creditors. Although their numbers may not be exactly the same, they will be in the same ballpark. That will give you a reasonable frame of reference for your debt ratio, letting you know whether it's too high or right on target.
One critical financial ratio often used by creditors is the debt ratio, but it's an important piece of information for you as well, especially if you plan to take on more debt. The debt ratio is calculated by dividing total liabilities by total assets (both of these numbers come right off your balance sheet). When this ratio runs high, meaning close to 1.0, that indicates a bigger risk of failure for the company. Debt ratios between 0.5 and 1.0 show that your business is financed mainly by debt. That debt consumes both your cash and your profits, making it harder for your equity to grow and for your company to add more debt when necessary.
Investment ratios let you know how much you're earning on your investment in the business. After all, one of the reasons you started your own business was to make some money, and it's important to know just how much that is. Even if you're getting a salary from your company, you should also be earning profits from your investment. The quickest way to measure that is to calculate the return on investment (ROI) ratio, which measures how well the company is using its assets to generate profits. You calculate this ratio by dividing your net profits by your total assets (net profits comes from the statement of profit and loss; total assets from the balance sheet). As you'd expect, a higher ROI is better, because that means you're earning more on your investment. At the very least, a healthy ROI should provide more return than you'd get if you put your money into a standard savings account.
Using Ratio Analysis
The numbers used in this ratio analysis come from the 2005 financial statements for Joan's Colorful Kites, used for the vertical and horizontal analyses performed earlier in this chapter.
First, a look at the profitability ratios, which actually appear on the vertical analysis. The gross profit margin came to 61.11 percent, calculated by dividing the $11,000 gross profit by the $18,000 in sales. The operating profit margin, in this case equal to the net profit margin (since there are no income taxes or interest expenses), came to 5.28 percent. That margin was calculated by dividing the bottom-line profit of $950 by the total sales of $18,000.
Next come the liquidity ratios. The current ratio for Joan's Colorful Kites equals 1.24, computed by dividing total current assets ($2,850) by total current liabilities ($2,300). This result indicates that Joan has sufficient current assets to cover her current liabilities. The quick ratio, however, paints a different picture. This ratio comes to only 0.37, which means that when you take inventory out of the equation, the company has only $0.37 to pay down each $1.00 of current debt.
Now take a look at the company's debt and investment ratios. The debt ratio is on the high side, but not so high that Joan would have a hard time getting a business loan. When you divide the total liabilities of $2,300 by the total assets of $4,250, the result is a debt ratio of 54.12 percent. Last, but not least, comes Joan's ROI. The net profits of $950 divided by the total assets of $4,250 provides Joan a 22 percent return, much higher than she'd receive if she turned those assets into a savings account.