Financial Ratios

1. Introduction
2. Liquidity Ratios
3. Solvency Ratios
4. Efficiency Ratios
5. Profitability Ratios
6. Limitations of Ratio Analysis
7. Useful Links
   
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1. Introduction
It is often difficult to look at a profit and loss account or a balance sheet and derive a full picture. As a result, financial ratios are often used to interpret accounts. A ratio is simply a relationship between two numbers. When compared to the same ratios in the accounts for previous periods, trends and patterns of performance can be seen. They can also be compared with the same ratios for other businesses operating in a similar environment - giving an idea of relative performance. Ratios are published for many business sectors which can be used as a comparison (these are sometimes referred to as 'industry norms').

Ratios can be used to assess:

1. Liquidity - the amount of working capital available.
2. Solvency - how near the business is to bankruptcy.
3. Efficiency - how good the management is.
4. Profitability - is the business a good investment?

2. Liquidity Ratios
A business should always have enough current assets, e.g. stock, work in progress, debtors, cash in the bank, to cover current liabilities, e.g. bank overdraft, creditors. Liquidity ratios indicate the ability to meet liabilities with the assets available.

1. Current Ratio
   The current ratio shows the relationship of current assets to current liabilities. It shows the ability of the business to meet short-term debts with current assets. This ratio should normally be between 1.5 and 2. Some people argue that the current ratio should be at least 2 on the basis that half the assets might be stock. A ratio of less than 1, i.e. current liabilities exceed current assets, could mean insolvency. A high current ratio could indicate over-investment in current assets, e.g. giving customers too much credit.
2. Quick Ratio (Acid Test)
   A stricter test of liquidity is the quick ratio or acid test. This ratio measures the ability of the business to meet short-term liabilities from liquid assets, e.g. cash. Some current assets, such as work in progress and stock, may be difficult to turn quickly into cash. Deducting these from the current assets gives the quick assets. The quick ratio should normally be around 0.7-1. To be absolutely safe, the quick ratio should be at least 1, which indicates that quick assets exceed current liabilities. If the current ratio is rising and the quick ratio is static, there is almost certainly a stockholding problem.
3. Defensive Interval
   Some people find it helpful to calculate the 'defensive interval'. This is the best measure of impending insolvency and shows the number of days the business can exist if no more cash flows into the business. As a guide, it should be 30-90 days, though it depends on the industry.

3. Solvency Ratios
If the net worth of the business becomes negative, i.e. total liabilities exceed total assets, then the business has become insolvent. That is, if the business closed it would not be possible to repay all the people who are owed money. Allowing a company to become insolvent is an offence, so care should be taken to watch the figures closely.

1. Gearing Ratio
   The gearing ratio gives an indication of solvency. It is normally defined as the ratio of debt, i.e. loans from all sources including debentures, term loans and overdraft, to total finance, i.e. shareholders' capital, reserves, long-term debt and overdraft. The higher the proportion of loan finance, the higher the gearing.
   
   The gearing should not be greater than 50%, although it often is for new, small businesses. If cash flow is stable and profit is fairly stable, then the business can afford a higher gearing.
2. Dividend Cover
   The dividend cover ratio is the amount of times that dividends are covered by profits. The stockmarket benchmark is 2. If dividend cover is less than 1, nothing is being invested to help the business in the long term. However, if dividend cover is greater than 4, shareholders will feel that they are not getting their fair share of the profits.
3. Interest Cover
   In addition to watching the gearing, bankers will also want to be satisfied that the business will be able to pay the interest on any loans. Therefore, they particularly look at how many times the profit exceeds their interest charges. A business with low interest cover may be unable to meet future payments if profits were to fall.
   
   Generally, the measure of risk should not be decreasing. The nearer the interest cover gets to 1, the greater the problem and this may indicate potential problems if interest rates were to rise. If it is more than 4 it is very good.

4. Efficiency Ratios
Efficiency ratios provide a measure of how much working capital is tied up, indicate how quickly the business collects outstanding debts (and pays its creditors) and show how effective the business is in making money work.

1. Debtors' Turnover Ratio
   Ideally, the average debtors for the period should be used. An approximation is given by dividing the sales by the debtors at the end of the period. Dividing this ratio into 365 days gives the average collection period in days.
2. Debtors Collection Period
   Tight credit control is essential. The debtors collection period measures how long it takes to collect the cash from a customer after making a sale. The collection period should be kept as short as possible. Many businesses aim to operate on a 30-day period, but often find it is longer than that.
3. Creditors Payment Period
   Monitoring how long it takes to pay suppliers is as important as knowing how long customers take to pay the business. If suppliers have to wait too long, they may withdraw credit facilities. The creditors payment period measures how long the business takes to pay suppliers for items bought on credit.
4. Stock Turnover Ratio
   Stock will increase in times of expansion and decrease in times of contraction. For some businesses, such as wholesalers and some retailers, a high stock turnover ratio is essential in order to make any profit. A low stock turnover could indicate the presence of slow moving stock, which should be disposed of rapidly.

It is also often helpful to know how quickly the stock is turned over.

5. Profitability Ratios
There are a number of simple profitability indicators that can be used. The gross profit margin is one figure to watch closely.

1. Gross Profit Margin
2. Net Profit Margin
   The net profit margin measures the rate at which profit is generated on sales and it should also be monitored.
3. Return on Capital Employed (ROCE)
   Some funders will want to know the return on the capital employed. This shows the business's ability to generate returns on the funds invested. It will show the element of risk involved in investing in the business and it can be compared with interest rates for investments where there is very low risk, e.g. if the same sum of money had been put in a building society or invested on the stock market. For a small business, where the proportion of short term debt is high, it is recommended that capital employed is defined as equity plus long term debt plus short term debt.

6. Limitations of Ratio Analysis
Ratio analysis is a very useful way to interpret business accounts. However, there are several limitations involved:

1. Inconsistency
   When comparing ratios with other businesses, it is difficult to know whether the same accounting methods have been used, even though accounting principles and standards have been developed. Examples include methods of depreciation and stock valuation where different businesses may use different techniques.
2. Inflation
   When ratios are being used to assess trends over a number of years, fluctuations could be due to inflation levels, rather than performance. This could result in misleading figures so adjustments should be made to reflect the rate of inflation in the periods being considered.
3. Seasonality
   Ratios, which are calculated from information in the balance sheet normally, use year-end figures. This can result in a distorted picture of the business if its performance is seasonal.
4. Subjectivity
   Conclusions which are drawn from accounting information will reflect any judgements made by those who have been preparing it. Some of the figures needed for the ratios may not be available and therefore alternatives will be used which aren't as precise. It is important to consider this when reading accounts from other businesses. Despite these limitations, ratio analysis is a very useful method of analysing business performance. Ratios should be treated as an indication of where to look to find reasons for financial performance. They should not be used in isolation.

7. Useful Tips

1. Ratios are normally judged against the industry norms and against the business' own performance record; they can tell very little in isolation. The key use of ratios is to examine trends and identify problems. Ratios will never solve problems but they might help to identify the cause.
2. The smaller the business, the more important it is to watch the cash flow, rather than relying on ratio analysis.
3. Ratios depend upon accurate, consistent financial information.