Day 4 Transactions, Ratios, and Analysis
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Explore: Transactions, Ratios, and Analysis.
Financial ratios are used to evaluate operating performance of the firm. For example, although earnings of $50,000 may look impressive, this is only meaningful in relation to other values. For example, $50,000 of earnings on $500,000 of sales may be very impressive (10% profit margin ratio) but it may be very lackluster if the $50,000 of earnings was on $5,000,000 of sales (1% profit margin ratio). Then, we can compare these results to those achieved by businesses in similar industries.
The thirteen ratios we will explore can be separated into four different categories (profitability ratios, asset utilization ratios, liquidity ratios, and debt utilization ratios).
Profitability ratios are used to measure a business’s ability to earn sufficient returns on sales, total assets, and invested capital.Asset utilization ratios are utilized to measure the number of times a business sells its inventory or collects all accounts receivable.The Liquidity ratio is used to measure a business’ ability to pay off short-obligations as they come due.Debt utilization ratios are used to evaluate the firm’s overall debt position, based on its asset base and earning power.
Note: There are other ratios in each category. We have chosen to focused on what we think to be the most important for small business management.
Profitability Ratios
Company A Industry Average
1. Profit Margin =Net Income/Sales $100,000/$2,000,000 = 5% 3%
What this tells us: How well our business is turning sales into profit. Thelarger this number is, the better because it indicates that our business isefficient.
2. Return on Assets (investment)=Net Income/ Total Assets: $250,000/$2,000,000= 12.5% 10%
What this tells us: The percentage of profit a company earns in relation toits overall resources, this tells us how well our investment in our business isworking. The larger this number is, the better.
Asset Utilization Ratios
Company A Industry Average
Receivables Turnover=Sales (credit)/Receivables $3,000,000/$300,000=10 9
What this tells us: This ratio tells us how effectively we are collecting on our receivable accounts. The optimal number for this ratio depends on how much of your sales are on account. Generally speaking, you want to collect your accounts faster, which means this number would be larger. Warning: If your business uses accounts receivable (not all do or should), then you don’t want to collect so quickly that your customers see no advantage in buying on account. If this happens, you may lose customers to your competitors.What is a receivable? A receivable is when you make a sale on credit and the customer will pay you at some future time. This may be a credit card purchase or credit that you extend to your customer. Generally speaking, businesses that have high priced items (cars, jewelry, etc.) or provide services over a period of time (construction, etc.) will use accounts receivable. Businesses that provide goods or services immediately (grocery store, restaurant, etc.) do not tend to use accounts receivable.
Inventory Turnover=
Sales/Inventory $3,000,000/$300,000= 10 11
What this tells us: How effectively your business is selling all of its inventory. This number indicates how many times a year you sold all of your inventory. The larger this number is, the better. Warning: This number can look high if your business does not carry enough inventory. You have to find the right level of inventory that keeps your customers happy but does not sit in inventory for a long period of time. You will learn this with experience.
Liquidity Ratio
Company A Industry Average
Current Ratio=Current Assets/Current Liabilities $1,000,000/400,000=2.5 2
What this tells us: This ratio gives us an idea of a company's ability to pay its bills. The general rule is that this ratio should be between 1 and 2. If it is consistently below 1, then the business may have trouble paying its immediate bills. If it is consistently above 2, that may mean that the business is not using its assets efficiently.
Debt Utilization Ratios
Not all firms, especially small businesses will have debt, and these ratios will not apply to a firm that does not have debt. But, for businesses that do have debt, managing it very carefully is essential.
Company A Industry Average
Debt to Total Assets=Total Debt/Total Assets $500,000/$2,000,000=25% 27%
What this tells us: This tells us the business’ long term debt payoff situation. It gives us a measure of the business’ long term financial viability. The larger this number is, the higher risk this business has of going bankrupt. Note: Some businesses, by their nature, will have more debt than others. For instance, a business that requires much equipment will usually have more debt and so it is important to put this number in context. A trucking business that has borrowed money to purchase a new truck will have more debt than a gardening business that only uses low cost hand tools.
Times Interest Earned=
Income before interest and taxes/interest $450,000/$45,000=10 8What this tells us: This tells us the business’ ability to make its regular payments on its debt. This is a short term measure of the business’ financial strength. The larger this number is, the better.