Thursday, October 28, 2010

Ratio Analysis: Part 1

Financial analysts often recommend ratio analysis as a way to measure the condition of a business. Many small business owners don’t know how to calculate the ratios or don’t understand what the ratios are telling them. We will discuss how to calculate important ratios and what they mean.

Financial ratios can be classified into four groups: liquidity ratios, activity ratios, leverage ratios, and profitability ratios. This week we will discuss liquidity ratios and leverage ratios.

Liquidity ratios help measure a business' ability to generate sufficient cash flow to pay it's current bills.
Liquidity is necessary to all business especially during economic downturns or slow periods for a company.

Current Ratio: This ratio is subject to seasonal fluctuations and is used to measure the ability of the business to meet its current liabilities out of current assets. A high ratio is needed if the business has difficulty borrowing on short notice.

      Current Ratio = Current Assets/Current Liabilities

Quick (Acid-Test) Ratio: The quick ratio, also known as the acid-test ratio is an even stricter measure of liquidity and is what saved many businesses when the economy fell apart in 2009.

    Quick Ratio = (Cash + Short Term Investments + Accounts Receivable)/Current Liabilities
Leverage (Solvency) Ratios. Solvency is the ability of the business to pay its long-term debts as they become due. An analysis of solvency looks at the long-term financial and operating structure of a business. The amount of long-term debt the business has is also considered. Solvency is affected by profitability, since in the long run no business will be able to meet its debts unless it is profitable.

Debt Ratio: The debt ratio compares total liabilities to total assets. It shows the percentage of total funds obtained from creditors. The more funding a business has from creditors, the more risk from a decrease in revenue and/or a decrease in profitability.

       Debt Ratio = Total Liabilities/Total Assets

Times Interest Earned (Interest Coverage) Ratio: The times interest earned ratio reflects the number of times before-tax earnings cover interest expense. It is a safety margin indicator in the sense that it shows how much of a decline in earnings a business can safely survive.

     Interest Coverage = Earnings before Interest and Taxes/Interest Expense

The key to all ratio analysis is what you compare the ratios to.  Industry standards are important as well as the business' own history.

Next week, we will discuss activity and profitability ratios.  What is your favorite ratio?

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