- Writing a Business Plan
- Financial Statements
- Business Forecasting
- Business Checklist
Part 1 - Calculating Ratios
Part 1 of this section teaches you how to calculate ratios. The most common ratios can be classified into four (4) categories; Liquidity Ratios, Activity Ratios, Leverage Ratios, and Profitability Ratios.
LIQUIDITY RATIOS measure a company's abilities to provide sufficient cash to cover its short term obligations. The most common liquidity ratios include; the current ratio and the quick ratio.
ACTIVITY RATIOS indicate how much a company has invested in a particular type of asset (or group of assets) relative to the revenue the asset is producing. The most common activity ratios include; the average collection period ratio and the inventory turnover ratio.
LEVERAGE RATIOS measures a company's use of debt to finance its operations. The most common leverage ratios include; debt ratio and debt-to-equity ratio.
PROFITABILITY RATIOS are of great importance to investors since they measure how effectively a firm's management is generating profits on sales, total assets, and stockholders' investment. The most common profitability ratios include; gross profit margin ratio, net profit margin ratio, return on total assets ratio, and return on equity ratio.
To further explain each class of ratio as well as each type of ratio, lets use the following 200Y Balance Sheet and Income Statement for the Widget Manufacturing Company. Please note, we will be using the following financial statements throughout this entire section to develop ratios for the Widget Manufacturing Company.
|WIDGET MANUFACTURING COMPANY
AS OF DECEMBER 31, 200Y
|Current Assets:||Current Liabilities:|
|Cash||$ 2,550||Accounts Payable||$ 9,500|
|Marketable securities||$ 2,000||Short-term Bank Loan||$11,375|
|Account Receivable (Net)||$16,675||Total Current Liabilities||$20,875|
|Total Current Assets||$47,695||Total Long Term Debt||$24,000|
|Plant & Equipment||$41,000||EQUITY:|
|Less: Accumulated Depreciation||$11,000||Common Shares||$25,000|
|Net Plant & Equipment||$30,000||Retained Earnings||$ 7,820|
|Total Liabilities & Equity||$77,695|
|Widget Manufacturing Company
Condensed Income Statement
For Year Ending Dec. 31, 200Y
|Sales from Widgets||$112,500|
|Cost of Goods Sold (COGS)||$ 85,040|
|Gross Margin||$ 27,460|
|Operating Expenses (Marketing & Administrative)||$ 18,950|
|Net Income Before Taxes||$ 8,510|
|Less: Income Taxes||$ 4,163|
|Net Income After Taxes||$ 4,347|
Additional Information Required:
No dividends were declared or paid to the owners during 200Y
The Widget Manufacturing Company's beginning inventory on January 1, 200Y was valued at $22,500. Average inventory is calculated by adding the beginning & ending inventories together and dividing the sum by 2.
Now we have enough information to begin calculating the Widget Manufacturing Company's ratios. Lets start by calculating the company's liquidity ratios (see below).
Calculation of Widget Manufacturing Company's Ratios:
Summary of Ratio Example:
This concludes PART 1 - Calculating Ratios. In the above readings, we calculated ratios as of December 31 , 200Y for the Widget Manufacturing Company. We can briefly summarize the company's performance by saying;
- As of December 31, 200Y, the company has sufficient current assets to cover its short-term debts (Current Ratio).
- As of December 31, 200Y, the company does not have to rely heavily on selling its inventory to pay its short term debt (Quick Ratio).
- On average, the company's customers pay within 54 days from date of purchase, for products brought on credit (Average Collection Period Ratio).
- The company used or consumed its inventory an average of 3.5 times during 200Y (Inventory Turnover Ratio)
- As of December 31, 200Y, 58% of the company's assets are owned by creditors such as bank, suppliers, and vendors (Debt Ratio). This indicates the company is paying high interest charges.
- Creditors are providing more money towards financing the company's operations than the owners (Debt-to-Equity Ratio).
- The company makes 24 cents on every dollar generated in sales (Gross Profit Margin Ratio). These funds are used to pay the company's operating expenses, tax obligation, dividends, etc...
- In 200Y, the company earned 4 cents (after tax) on every dollar generated in sales. Moreover, after product costs, operating expenses & taxes are considered, 4 cents is left over to contribute to net income, or to be distributed to the owners, or a combination of both (Net Profit Margin Ratio).
- In 200Y, the company used its assets to generate 6 cents in after tax profits (Return on Total Assets Ratio).
- In 200Y, the owners received a 13% rate of return on their investment (Return on Equity). Moreover, for every one dollar investment into the company by its owners, 13 cents were generated in after tax profits.
Being able to calculate the above ratios is important, however, understanding the meaning behind each should be your focus. When reviewing each ratio, ask yourself this question "what does this ratio attempt to calculate"?
This concludes PART 1 - "Calculating Ratios".
Examples of Ratio Calculations: