What business ratios should you know and be using? Here’s a breakdown of common ratios, how they’re used, and in some cases how you’ll calculate them.
Current. Measures company’s ability to meet financial obligations. Expressed as the number of times current assets exceed current liabilities. A high ratio indicates that a company can pay its creditors. A number less than one indicates potential cash flow problems.
Quick. This ratio is very similar to the Acid Test (see below), and measures a company’s ability to meet its current obligations using its most liquid assets. It shows Total Current Assets excluding Inventory divided by Total Current Liabilities.
Total Debt to Total Assets. Percentage of Total Assets financed with debt.
Pre-Tax Return on Net Worth. Indicates shareholders’ earnings before taxes for each dollar invested. This ratio is not applicable if the subject company’s net worth for the period being analyzed has a negative value.
Pre-Tax Return on Assets. Indicates profit as a percentage of Total Assets before taxes. Measures a company’s ability to manage and allocate resources.
Net Profit Margin. This ratio is calculated by dividing Sales into the Net Profit, expressed as a percentage.
Return on Equity. This ratio is calculated by dividing Net Profit by Net Worth, expressed as a percentage.
Accounts Receivable Turnover. This ratio is calculated by dividing Sales on Credit by Accounts Receivable. This is a measure of how well your business collects its debts.
Collection Days. This ratio is calculated by multiplying Accounts Receivable by 360, which is then divided by annual Sales on Credit. Generally, 30 days is exceptionally good, 60 days is bothersome, and 90 days or more is a real problem.
Inventory Turnover. This ratio is calculated by dividing the Cost of Sales by the average Inventory balance.
Accounts Payable Turnover. This ratio is a measure of how quickly the business pays its bills. It divides the total new Accounts Payable for the year by the average Accounts Payable balance.
Payment Days. This ratio is calculated by multiplying average Accounts Payable by 360, which is then divided by new Accounts Payable.
Total Asset Turnover. This ratio is calculated by dividing Sales by Total Assets.
Debt to Net Worth. This ratio is calculated by dividing Total Liabilities by total Net Worth.
Current Liab. to Liab. This ratio is calculated by dividing Current Liabilities by Total Liabilities.
Net Working Capital. This ratio is calculated by subtracting Current Liabilities from Current Assets. This is another measure of cash position.
Interest Coverage. This ratio is calculated by dividing Profits Before Interest and Taxes by total Interest Expense.
Assets to Sales. This ratio is calculated by dividing Assets by Sales.
Current Debt/Total Assets. This ratio is calculated by dividing Current Liabilities by Total Assets.
Acid Test. This ratio is calculated by dividing Current Assets (excluding Inventory and Accounts Receivable) by Current Liabilities.
Sales/Net Worth. This ratio is calculated by dividing Total Sales by Net Worth.
Dividend Payout. This ratio is calculated by dividing Dividends by Net Profit.
In the real world, financial profile information involves some compromise. Very few organizations fit any one profile exactly. Variations, such as doing several types of business under one roof, are quite common. If you cannot find a classification that fits your business exactly, use the closest one and explain in your text how and why your business is different from the standard.
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Tim Berry is the founder and chairman of Palo Alto Software , a co-founder of Borland International, and a recognized expert in business planning.
He has an MBA from Stanford and degrees with honors from the University of Oregon and the University of Notre Dame. Today, Tim dedicates most of his time to blogging, teaching and evangelizing for business planning.