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Business Basics

Part four- Finance and Ratio Analysis

By now you already know all about the financial statements and tools in making smart decisions. But one thing is still missing- how do we measure the success of these decisions? How do we know how are company is really doing financially?

Easy- we use ratio analysis.

Ratio analysis means just this- you take figures from the financial statements and compare them. You then compare there with rules, industry standards and other ratios to come up with an evaluation of your company's financial success.

Short term viability- liquidity

Liquidity ratios measure how well your company can cover its short term debt. A few basic ratios include:

- Current ratio: current assets/current liabilities. This should be approximately 2:1. Any less is too low, you can't cover your liabilities well, but any more means you should borrow more money and expand.

- Acid test: (current assets less inventory and non liquid assets)/current liabilities. This should be 1:1, any less means you're in real trouble- too much money is tied up in inventories you're not selling and you can't cover your short term obligations. If it's too high your inventory may be too low.

- Account receivables collection period: (365 * accounts receivables)/annual sales. This figure should be compared to your credit terms and industry standards. If your turnover is longer than your credit terms, customers aren't paying you on time- you should increase your interest penalty and grant less credit to unreliable people. If it's too short, you should reduce discount terms and grant more credit to customers, because you're losing potential sales.

- Inventory turnover: sales/inventory. Compare with industry standards. If it's too high, you should hold more inventory because you're losing sales. If it's too low, hold less inventory because this is typing up your cash.

Long term viability- Stability

Stability measures the same thing liquidity measures only in the long run. They're both important for any business. The ratios include:

- Debt/equity ratio: total liabilities/owner's equity. Should be less than 1:1- more means you have too much debt, less means you should borrow more to finance your business.

- Leverage: Long term liabilities/owner's equity. Should be between 0.5:1 and 1:1. Anything lower means your capital structure could use more debt financing to optimize your sources of capital. Anything higher means you owe too much and can't cover your debts well.

- Interest coverage: EBIT/interest. If it's less than 3:1, you're not earning enough to cover your interest. If it's really high, consider using more debt financing.

Making some money- Profitability

The profitability ratios tell you how much you're earning. If they're too low, you're not doing well. The ratios are:

- Gross profit margin: gross profit/net sales. If this is lower than industry average, you're not selling enough.

- Net profit margin: net profit/net sales. Too low means expenses are too high.

- Return on investment: net income/owner's equity. The higher this is, the better off you are, because it means you're getting a good profit on your investment. This is the single most important ratio in terms of how you're doing financially.

Growth ratio

The growth ratios are used for comparisons between this year and previous years on several of the company's figures. These include growth of income, sales, and other ratios from earlier years. The formula to calculate them is:

Of course, if growth is positive and high, this is a good sign.

And lastly- marketability

Marketability ratios signify how well your shares are doing in the market.

- EPS, earnings per share: earnings available/number of shares. We've seen this in EBIT- the higher, the better.

- Price/earnings ratio: stock price/EPS. Higher means your company has a good public image.

- Payout: dividend per share/EPS. Higher means you pay out more dividends, so you're making more money, but too high suggests you should increase retained earnings.

Using these ratios you can figure out how your company is doing

This is it for finance and accounting, and numerical values. Part 5 of Business Basics will deal with operations and human resources- making your actual products.