Balance Sheet Financial Ratio Analysis

What is ratio analysis? The Balance Sheet and the Statement of

Income are essential, but they are only the starting point for
successful financial management. Apply Ratio Analysis to
Financial Statements to analyze the success, failure, and progress
of your business.
Ratio Analysis enables the business owner/manager to spot
trends in a business and to compare its performance and
condition with the average performance of similar businesses in
the same industry. To do this compare your ratios with the
average of businesses similar to yours and compare your own
ratios for several successive years, watching especially for any
unfavorable trends that may be starting. Ratio analysis may
provide the all-important early warning indications that allow you
to solve your business problems before your business is
destroyed by them.
Balance Sheet Ratio Analysis Formula
Important Balance Sheet Ratios measure liquidity and solvency (a
business's ability to pay its bills as they come due) and leverage
(the extent to which the business is dependent on creditors'
funding). They include the following ratios:
Liquidity Ratios
These ratios indicate the ease of turning assets into cash. They
include the Current Ratio, Quick Ratio, and Working Capital.
Current Ratios. The Current Ratio is one of the best known
measures of financial strength. It is figured as shown below:
Current Ratio =
Total Current Assets
____________________
Total Current Liabilities

The main question this ratio addresses is: "Does your business
have enough current assets to meet the payment schedule of its
current debts with a margin of safety for possible losses in
current assets, such as inventory shrinkage or collectable
accounts?" A generally acceptable current ratio is 2 to 1. But
whether or not a specific ratio is satisfactory depends on the
nature of the business and the characteristics of its current assets
and liabilities. The minimum acceptable current ratio is obviously
1:1, but that relationship is usually playing it too close for
comfort.
If you decide your business's current ratio is too low, you may be
able to raise it by:
Paying some debts.
Increasing your current assets from loans or other
borrowings with a maturity of more than one year.
Converting non-current assets into current assets.
Increasing your current assets from new equity
contributions.
Putting profits back into the business.
Quick Ratios. The Quick Ratio is sometimes called the "acidtest" ratio and is one of the best measures of liquidity. It is
figured as shown below:
Quick Ratio =
Cash + Government Securities + Receivables
______________________________________
Total Current Liabilities
The Quick Ratio is a much more exacting measure than the
Current Ratio. By excluding inventories, it concentrates on the
really liquid assets, with value that is fairly certain. It helps
answer the question: "If all sales revenues should disappear,
could my business meet its current obligations with the readily
convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority

of your "quick assets" are in accounts receivable, and the pattern
of accounts receivable collection lags behind the schedule for
paying current liabilities.
Working Capital. Working Capital is more a measure of cash
flow than a ratio. The result of this calculation must be a positive
number. It is calculated as shown below:
Working Capital = Total Current Assets - Total Current Liabilities
Bankers look at Net Working Capital over time to determine a
company's ability to weather financial crises. Loans are often tied
to minimum working capital requirements.
A general observation about these three Liquidity Ratios is that
the higher they are the better, especially if you are relying to any
significant extent on creditor money to finance assets.
Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which
the business is reliant on debt financing (creditor money versus
owner's equity):
Debt/Worth Ratio =
Total Liabilities
_______________
Net Worth
Generally, the higher this ratio, the more risky a creditor will
perceive its exposure in your business, making it correspondingly
harder to obtain credit.
Income Statement Ratio Analysis
The following important State of Income Ratios measure
profitability:
Gross Margin Ratio
This ratio is the percentage of sales dollars left after subtracting
the cost of goods sold from net sales. It measures the percentage

of sales dollars remaining (after obtaining or manufacturing the

goods sold) available to pay the overhead expenses of the
company.
Comparison of your business ratios to those of similar businesses
will reveal the relative strengths or weaknesses in your business.
The Gross Margin Ratio is calculated as follows:
Gross Margin Ratio =
Gross Profit
_______________
Net Sales
(Gross Profit = Net Sales - Cost of Goods Sold)
Net Profit Margin Ratio
This ratio is the percentage of sales dollars left after subtracting
the Cost of Goods sold and all expenses, except income taxes. It
provides a good opportunity to compare your company's "return
on sales" with the performance of other companies in your
industry. It is calculated before income tax because tax rates and
tax liabilities vary from company to company for a wide variety of
reasons, making comparisons after taxes much more difficult. The
Net Profit Margin Ratio is calculated as follows:
Net Profit Margin Ratio =
Net Profit Before Tax
_____________________
Net Sales
Management Ratios
Other important ratios, often referred to as Management Ratios,
are also derived from Balance Sheet and Statement of Income
information.
Inventory Turnover Ratio
This ratio reveals how well inventory is being managed. It is
important because the more times inventory can be turned in a

given operating cycle, the greater the profit. The Inventory

Turnover Ratio is calculated as follows:
Inventory Turnover Ratio =
Net Sales
___________________________
Average Inventory at Cost
Accounts Receivable Turnover Ratio
This ratio indicates how well accounts receivable are being
collected. If receivables are not collected reasonably in
accordance with their terms, management should rethink its
collection policy. If receivables are excessively slow in being
converted to cash, liquidity could be severely impaired. The
Accounts Receivable Turnover Ratio is calculated as follows:
Net Credit Sales/Year
__________________ = Daily Credit Sales
365 Days/Year
Accounts Receivable Turnover (in days) =
Accounts Receivable
_________________________
Daily Credit Sales
Return on Assets Ratio
This measures how efficiently profits are being generated from
the assets employed in the business when compared with the
ratios of firms in a similar business. A low ratio in comparison
with industry averages indicates an inefficient use of business
assets. The Return on Assets Ratio is calculated as follows:
Return on Assets =
Net Profit Before Tax
________________________
Total Assets
Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the

percentage of return on funds invested in the business by its
owners. In short, this ratio tells the owner whether or not all the
effort put into the business has been worthwhile. If the ROI is
less than the rate of return on an alternative, risk-free investment
such as a bank savings account, the owner may be wiser to sell
the company, put the money in such a savings instrument, and
avoid the daily struggles of small business management. The ROI
is calculated as follows:
Return on Investment =
Net Profit before Tax
____________________
Net Worth
These Liquidity, Leverage, Profitability, and Management Ratios
allow the business owner to identify trends in a business and to
compare its progress with the performance of others through
data published by various sources. The owner may thus
determine the business's relative strengths and weaknesses.
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