Financial Ratio Analysis

Dennis L. Thompson, CPA

Nine Ratios that Measure Effect Current Assets/Current Liabilities

Current Liabilities/Net Worth

Total Liabilities/Net Worth

Inventory/Working Capital

Accounts Receivable/Working Capital

Long Term Liabilities/Working Capital

Net Profit/Net Worth

Net Sales/Fixed Assets

Net Sales/Working Capital

Six Causal Ratios Fixed Assets/Net Worth

Days Sales in Accounts Receivable

Accounts Receivable/(Credit Sales/360)

Net Sales/Inventory

Net Sales/Net Worth

Net Profit/Net Sales

Misc Assets/Net Worth

The Meaningful Interpretation of Financial Statements – Donald E. Miller

Fixed Assets/Net Worth

• Measures extent that Net Worth consists of long term, non current assets.

• Can have negative impact on Working Capital and Current Ratio.

• Might be increasing Fixed Costs through borrowing.

• Might be distorted by low Net Worth

Accounts Receivable/(Credit Sales/360)- Collection Period

• Measures efficiency of Company receivable collections.

• Early warning system for delinquent accounts.

• Important to measure against Industry competitors.

• Need to subtract cash sales to arrive at net Credit Sales.

• Low number can be indicative of restrictive Credit Policy, thus reducing profit.

Net Sales/Inventory=Number of Times• Measures how quickly Inventory is turning

over.• Low turnover indicates potential writeoffs.• Also could indicate potential shrinkage.• Could adversely impact Cash Flow.• However, with Inventory management,

need to seek a balance of too much and not enough.

Net Sales/Net Worth

• Measures extent Company’s sales are supported by invested capital.

• High ratio can mean that Company is supporting sales through debt, i.e., Fixed Costs.

• Can negatively impact Break-Even point.

• Can increase chances of Company failure because of Fixed Costs.

• Over emphasis on sales can lead to selling to marginal customers.

Net Profit/Net Sales• Impacts all the other ratios.

• Profits add to Net Worth

• Losses increase the need for Long Term Borrowing, which can impact Working Capital.

• Losses threaten Company’s ability to survive.

Misc Assets/Net Worth

• Examples : Loans to Employees

• Prepaid Expenses

• Usually not a significant part of Balance Sheet.

• Don’t want to tie up much Captal in these type of assets.

Current Assets/Current Liabilities

• Standard used to be 2:1

• Working Capital = Current Assets-Current Liabilities.

• Problem with Current Assets

– Includes Inventory

– Includes Receivables

Summary

• Financial Ratio Analysis can serve as an early warning system.

• Ratio Analysis assumes that Accounting information is accurate.

• Improve your Company’s chances for improved Profitability or even Survival by conducting Ratio Analysis.

• Especially important to compare your Company to Industry Standard Ratios.