COMMON
FINANCIAL RATIOS USED BY MRHVAC.COM
Collection
period ratio is helpful in analyzing the “collectability” of accounts
receivable, or how fast a business can increase its cash supply. Although
businesses establish credit terms, their customers for one reason or another do
not always observe them. In analyzing a business, you must know the credit
terms it offers before determining the quality of its receivables. While each
industry has its own average collection period (number of days it takes to
collect payments from customers), there are observers who feel that more than
10 to 15 days over terms should be of concern. Example Dealer, Inc. terms of
sale are net (or full amount) due within 30 days. Its average collection period
was 43.18 days based on current year end financial statements, up from 24.3 days in 1988. While
the trend for Example Dealer, Inc. is downward, its receivables are still being
converted to cash faster than the industry median, which is approximately 48.0
days.
Formula: Accounts
Receivable \ Sales x 365 Days, or in the Example Dealer, Inc. example:
|
$109,700
x 365 = Average Collection
Period = 43.18 Days |
|
|
$927,236 Industry median or norm =
48.0 Days |
|
Sales to inventory
ratio provides a yardstick for comparing stock-to-sales ratios of a business
with others in the same industry. When this ratio is high, it may indicate a
situation where sales are being lost because a concern is being under-stocked and/or
customers are buying elsewhere. If the ratio is too low, this may show that
inventories are obsolete or stagnant. Example Dealer, Inc. average turnover is
11.17 times. The industry average was approximately12.6 times annually. Example
Dealer, Inc. below average turnover indicates the cash flow into the business
is slow, since inventories are being converted to cash only four times per
year.
Formula: Annual Net Sales \ Inventory, or in the
Example Dealer, Inc. Example:
$927,700 =
Average Inventory Turnover = 11.17 Times
$ 83,000
Industry median or norm = 12.6 Times
Assets to sales
ratio measures the percentage of investment in assets that is required to
generate the current annual sales level. If the percentage is abnormally high,
it indicates that a business is not being aggressive enough in its sales
efforts, or that its assets are not being fully utilized. A low ratio may
indicate a business is selling more than can be safely covered by its assets.
Example Dealer, Inc. has a 46 percent ratio. Compared to the industry median of
47.6 percent, this ratio appears to be adequate.
Formula: Total Assets \ Net Sales x 100, or
in the Example Dealer, Inc. example:
$433,000
= Assets to Sales = 46%
$927,236 Industry median or norm = 47.6%
Sales to net
working capital ratio measures the number of times working capital turns over
annually in relation to net sales. A high turnover rate can indicate
over-trading (an excessive sales volume in relation to the investment in the
business). This ratio should be reviewed in conjunction with the assets to
sales ratio.
A high turnover rate might also indicate that the business relies extensively
upon credit granted by suppliers or the bank as a substitute for an adequate margin
of operating funds. Example Dealer, Inc. registered 8.26 times. This appears to
be slightly better than the industry median of 7.2 times. Note: Working capital
is Current Assets less Current Liabilities.
Formula: Sales \ Net Working Capital, or in the
Example Dealer, Inc. example:
$927,236
= Sales to Net Working Capital = 8.26
Times
$112,150 Industry median or norm = 7.2 Times
Accounts payable to
sales ratio measures how the company pays its suppliers in relation to the
sales volume being transacted. A low
percentage would indicate a healthy ratio. Example Dealer, Inc. is 8 percent;
which should be of concern since the industry median is 5.3 percent. In all
probability, Example Dealer, Inc. is likely paying its bills too slowly and
missing out on some supplier discount incentives.
Formula: Accounts
Payable \ Net Sales x 100, or in the Example Dealer, Inc. example:
$80,100 =
Accounts Payable to Sales Ratio = 8%
$927,236 Industry median or norm = 5.3%
EFFICIENCY RATIO: CASH CONVERSION PERIOD
The cash conversion
period measures the average length of time necessary for cash to move from
cash, to inventory, to costs in excess of billings, to accounts receivable, and
back to cash. This conversion period is often called the length of business cycle for a heating and air conditioning
company. The calculation of this measure involves adding the average ages of
the receivables, inventory and costs in excess of billings.
Formula: Average
Age of Accounts Payable + Average Age of material Inventory + Average Age of
Cost and Estimated Earnings in Excess of Billings.
This ratio is
nothing more than subtracting the average age of accounts payable and the
average age of billings in excess of costs from the cash conversion period. We
find that most profitable dealers try to minimize the cash demand period by
keeping the average conversion and the average age of accounts payable both as
low as possible. One apparent shortcoming of this measure is the assumption. It
is realized that the cash cycle behaves somewhat sporadically, but is a helpful
measure in determining the stability of your firm’s cash position. The validity
of this measure is greatly enhanced if the calculations are made on a monthly
basis using 12 month trends in order to accurately evaluate any fluctuations
during the year. Use it to improve your cash position.
Formula: Cash
Conversion Period – Average Age of Accounts Receivable + Average Age of Cost
and Estimated Earnings in Excess of Billings.
SOLVENCY RATIO: QUICK RATIO
The quick ratio,
sometimes called the “acid test” or “liquid” ratio, measures the extent to
which a business can cover its current liabilities with those current assets
readily convertible to cash. Only cash and accounts receivable would be
included, as inventory and other current assets would require time and effort
to convert into cash. A minimum ratio of 1.0 to 1.0 ($1 of cash receivables to
$1 current liabilities) is desirable. Example Dealer, Inc. had a .87 to 1.0
(.87 cents to pay off $1 of liabilities).This indicates weakness, especially
when compared to the median for the industry.
Formula: Cash +
Accounts Receivable \ Current Liabilities x 100, or in the Example Dealer, Inc.
example:
$30,300 +
$109,700 = .87 (Industry median or norm = 1.2)
$160,850
The current ratio
expresses the working capital relationship of current assets to cover current
liabilities. A rule of thumb is that at
least 2 to 1 is considered a sign of sound financial strength. However, much
depends on the standards of the specific industry you are reviewing. Example
Dealer, Inc. shows a 1.7 to 1.0 ($1.70 to $1) as its current ratio. The
industry average is approximately 1.9. If a company’s inventory is slow in
selling, a stronger current ratio is required.
Formula: Current
Assets \ Current Liabilities x 100, or in the Example Dealer, Inc. example:
$273,000
$160,850 = 1.7 (Industry median or norm = 1.9)
Current liabilities
to net worth ratio indicates the amounts due creditors within a year as a
percentage of the owners or stockholders investment. The smaller the net worth
and the larger the liabilities, the less security for creditors. Normally a
business starts to have trouble when this relationship exceeds 80 percent.
Example Dealer, Inc. ratio shows 68.4 percent. The industry median or norm is
approximately 63.8%.
Formula: Current Liabilities \ Net Worth x
100, or in the Example Dealer, Inc. example:
$160,850 = 68.4% (Industry median or
norm = 63.8%)
$235,150
Current liabilities to inventory ratio
shows you, as a percentage, the reliance on available inventory for payment of
debt (how much a company relies on funds from disposal of unsold inventories to
meet its current debt). Example Dealer, Inc. shows a 193.79 percent. The
industry median is approximately 173.3 percent.
Formula: Current Liabilities \ Inventory x
100. In the Example Dealer, Inc. example:
$160,850 = Current Liabilities to Inventory Ratio = 193.79%
$83,000 Industry
median or norm = 173.3%
Total Liabilities to net worth ratio shows how all of
the companies debt relates to the equity of the owners or stockholders. The
higher this ratio, the less protection there is for the creditors of the
business. Example Dealer, Inc. ratio is shown at 84 percent and is
significantly below the industries. The industry median ratio is approximately
130.2 percent.
Formula: Total Liabilities \ Net Worth x
100, or in the Example Dealer, Inc. example:
$197,850
= Total Liabilities to Net Worth Ratio = 84%
(Industry median or norm + 130.2%)
$235,150
Fixed assets to net worth ratio shows the
percentage of assets centered in fixed assets compared to total equity.
Generally the higher this percentage is over 75 percent, the more vulnerable a
concern becomes to unexpected hazards and business climate changes. Capital is
frozen in the form of machinery and the margin for operating funds becomes too
narrow for day to day operations. Example Dealer, Inc. appears to have a
favorable ratio at 64 percent. The industry ratio median is approximately 48.0.
Formula: Fixed Assets \ Net Worth x 100. In
the Example Dealer, Inc. example:
$150,000 = 64% (Industry median or norm = 48.0%)
$235,150
PROFITABILITY
RATIO: RETURN ON SALES (PROFIT MARGIN)
Return on sales (profit margin) ratio
measures the profits after taxes on the year’s sales. The higher this ratio,
the better prepared the business is to handle downtrends brought on by adverse
conditions. Example Dealer, Inc. earned 10.21 percent. This compares with the industry median of
approximately 2.5 percent. In this
category, Example Dealer, Inc. performance is very good and well above the
industry average.
Formula: Net
Profit Before Taxes \ Net Sales x 100, or in the Example Dealer, Inc. example:
$94,747 = Return on Sales Ratio = 10.21%
(Industry median or norm = 2.5%)
$927,236
PROFITABILITY
RATIOS: RETURN ON ASSETS
Return on assets ratio is the key indicator
of the profitability of a company. It
matches net profits after taxes with the assets used to earn such profits. A high percentage rate will tell you the
company is well run and has a healthy return on assets. Example Dealer, Inc. has a 21.88 percent
return on assets. This is an excellent return in light of the industry median of
approximately 15 percent.
Formula:
Net Profit Before Taxes \ Total Assets x 100, or in the Example Dealer,
Inc. example:
$94,747 = Return on Assets Ratio = 21.88% (Industry median or norm = 5.7%)
$433,000
PROFITABILITY
RATIO: RETURN ON NET WORTH (RETURN OF EQUITY)
Return on net worth ratio measures the
ability of a company’s management to realize an adequate return on the capital
invested by the owners in the company.
Example Dealer, Inc. has earned 40.29 percent. This percentage is very good. The industry median is
approximately 20% to 25% percent.
Formula:
Net Profit Before Taxes \ Net Worth x 100, or in the Example Dealer,
Inc. example:
$94,747 = Return on Net Worth Ratio =
40.29% (Industry median or norm = 12.7%)
$235,150
KEY BUSINESS RATIOS
The 14 most widely used financial ratios.
Every Dun’s Financial Profile Report, PRO
Model Statement and Industry Norm Report delivers the advantage of D&E
Norms and Key Business Ratios. These
specific measures of business performance provide significant insights into a
companies financial condition, based on its performance compared to others in
its industry.
Ø
Simplifies the task of evaluating a companies financial condition by providing objective, quantitative measurements
of business performance.
Ø
Teamed with industry norms – as in the Customized
Information Systems and Services family of products and services – Key Business
Ratios allow quick comparison of a companies performance to others in its
industry.
Ø
Includes more than 800 lines of business
segmented by up to 15 asset ranges and four geographic areas.
Here’s what each of the 14 Key business
ratios used by customized information Systems and Services means:
Ø
QUICK RATIO: Cash \ Accounts Receivable \
Total Current Liabilities
Ø
CURRENT RATIO: Total Current Assets \ Total
Current Liabilities
Ø
CURRENT LIABILITIES TO NET WORTH: Total Current Liabilities \ Net Worth
This contrasts the amounts due creditors within a year with the funds
permanently invested by the owners. The
smaller the net worth and the larger the liabilities, the greater the risk.
Ø
CURRENT LIABILITIES TO INVENTORY: Total
Current Liabilities \ Inventory. This tells you how much a firm relies on funds
from disposal of unsold inventories to meet debt.
Ø
TOTAL LIABILITIES TO NET WORTH: Total
Liabilities \ Net Worth
The effect of long term debt on a business can be
determined by comparing this ratio with that of Current Liabilities to Net
Worth.
Ø
FIXED ASSETS TO NET WORTH: Fixed Assets \ Net Worth
The amount of net worth that consists of Fixed Assets
will vary greatly from industry to industry, but generally a smaller portion is
desirable.
Ø
COLLECTION PERIOD: Accounts Receivable \ Sales x 365 Days
Gives you an idea of the quality of receivables.
Ø
INVENTORY TURNOVER: Sales \ Inventory
When compared to industry norms this ratio tells you how fast inventory
is moving and the cash flow into business.
Ø
ASSETS TO SALES: Total Assets \ Sales
This rate ties in sales and the total investment that is used to
generate those sales.
Ø
SALES TO NET WORKING CAPITAL: Sales \ Net Working Capital
This measurement indicates whether a company is over-trading or,
conversely, carrying more liquid assets than needed for its volume.
Ø
ACCOUNTS PAYABLE TO SALES: Accounts Payable \ Sales
This measures how the company is paying its suppliers in relation to the
volume being transacted.
Ø
RETURN ON
SALES (Profit margin): Net Profit after
Taxes \ Sales
Tells you profits earned per dollar of sales and measures the efficiency
of the operation.
Ø
RETURN ON
ASSETS: Net Profit after Taxes \ Total
Assets
This is the key indicator of profitability for a firm. It matches operating profits with the assets
available to earn a return. A high rate
will tell you a company is well run and has a good return on assets.
Ø
RETURN ON NET
WORTH (Return of Equity):
Net Profit after Taxes \ Net Worth
Analyzes the ability of the firm’s
management to realize an adequate return on the capital invested by the owners
of the firm.
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