Financial ratios are relationships determined from a company's financial

information and used for comparison purposes. Examples include such

often referred to measures as return on investment (ROI), return on assets

(ROA), and debt-to-equity, to name just three. These ratios are the result

of dividing one account balance or financial measurement with another.

Usually these measurements or account balances are found on one of the

company's financial statements—balance sheet, income statement,

cashflow statement, and/or statement of changes in owner's equity.

Financial ratios can provide small business owners and managers with a

valuable tool with which to measure their progress against predetermined

internal goals, a certain competitor, or the overall industry. In addition,

tracking various ratios over time is a powerful means of identifying trends

in their early stages. Ratios are also used by bankers, investors, and

business analysts to assess a company's financial status.

Ratios are calculated by dividing one number by another, total sales

divided by number of employees, for example. Ratios enable business

owners to examine the relationships between items and measure that

relationship. They are simple to calculate, easy to use, and provide

business owners with insight into what is happening within their business,

insights that are not always apparent upon review of the financial
statements alone. Ratios are aids to judgment and cannot take the place of

experience. But experience with reading ratios and tracking them over

time will make any manager a better manager. Ratios can help to pinpoint

areas that need attention before the looming problem within the area is

easily visible.

Virtually any financial statistics can be compared using a ratio. In reality,

however, small business owners and managers only need to be concerned

with a small set of ratios in order to identify where improvements are

needed.

It is important to keep in mind that financial ratios are time sensitive; they

can only present a picture of the business at the time that the underlying

figures were prepared. For example, a retailer calculating ratios before and

after the Christmas season would get very different results. In addition,

ratios can be misleading when taken singly, though they can be quite

valuable when a small business tracks them over time or uses them as a

basis for comparison against company goals or industry standards.

Perhaps the best way for small business owners to use financial ratios is to

conduct a formal ratio analysis on a regular basis. The raw data used to

compute the ratios should be recorded on a special form monthly. Then the

relevant ratios should be computed, reviewed, and saved for future

comparisons. Determining which ratios to compute depends on the type of

business, the age of the business, the point in the business cycle, and any

specific information sought. For example, if a small business depends on a

large number of fixed assets, ratios that measure how efficiently these

assets are being used may be the most significant. In general, financial

ratios can be broken down into four main categories—1) profitability or

return on investment; 2) liquidity; 3) leverage, and 4) operating or

efficiency—with several specific ratio calculations prescribed within each.

PROFITABILITY OR RETURN ON INVESTMENT

RATIOS
Profitability ratios provide information about management's performance

in using the resources of the small business. Many entrepreneurs decide to

start their own businesses in order to earn a better return on their money

than would be available through a bank or other low-risk investments. If

profitability ratios demonstrate that this is not occurring—particularly

once a small business has moved beyond the start-up phase—then

entrepreneurs for whom a return on their money is the foremost concern

may wish to sell the business and reinvest their money elsewhere.

However, it is important to note that many factors can influence

profitability ratios, including changes in price, volume, or expenses, as

well as the purchase of assets or the borrowing of money. Some specific

profitability ratios follow, along with the means of calculating them and

their meaning to a small business owner or manager.

Gross profitability: Gross Profits/Net Sales—measures the margin on sales

the company is achieving. It can be an indication of manufacturing

efficiency, or marketing effectiveness.

Net profitability: Net Income/Net Sales—measures the overall profitability

of the company, or how much is being brought to the bottom line. Strong

gross profitability combined with weak net profitability may indicate a

problem with indirect operating expenses or non-operating items, such as

interest expense. In general terms, net profitability shows the effectiveness

of management. Though the optimal level depends on the type of business,

the ratios can be compared for firms in the same industry.

Return on assets: Net Income/Total Assets—indicates how effectively the

company is deploying its assets. A very low return on asset, or ROA,

usually indicates inefficient management, whereas a high ROA means

efficient management. However, this ratio can be distorted by depreciation

or any unusual expenses.

Return on investment 1: Net Income/Owners' Equity—indicates how well

the company is utilizing its equity investment. Due to leverage, this

measure will generally be higher than return on assets. ROI is considered

to be one of the best indicators of profitability. It is also a good figure to

compare against competitors or an industry average. Experts suggest that

companies usually need at least 10-14 percent ROI in order to fund future

growth. If this ratio is too low, it can indicate poor management

performance or a highly conservative business approach. On the other

hand, a high ROI can mean that management is doing a good job, or that

the firm is undercapitalized.

Return on investment 2: Dividends +/- Stock Price Change/Stock Price

Paid—from the investor's point of view, this calculation of ROI measures

the gain (or loss) achieved by placing an investment over a period of time.

Earnings per share: Net Income/Number of Shares Outstanding—states a

corporation's profits on a per-share basis. It can be helpful in further

comparison to the market price of the stock.

Investment turnover: Net Sales/Total Assets—measures a company's

ability to use assets to generate sales. Although the ideal level for this ratio

varies greatly, a very low figure may mean that the company maintains too
many assets or has not deployed its assets well, whereas a high figure

means that the assets have been used to produce good sales numbers.

Sales per employee: Total Sales/Number of Employees—can provide a

measure of productivity. This ratio will vary widely from one industry to

another. A high figure relative to one's industry average can indicate either

good personnel management or good equipment.

LIQUIDITY RATIOS
Liquidity ratios demonstrate a company's ability to pay its current

obligations. In other words, they relate to the availability of cash and other

assets to cover accounts payable, short-term debt, and other liabilities. All

small businesses require a certain degree of liquidity in order to pay their

bills on time, though start-up and very young companies are often not very

liquid. In mature companies, low levels of liquidity can indicate poor

management or a need for additional capital. Any company's liquidity may

vary due to seasonality, the timing of sales, and the state of the economy.

But liquidity ratios can provide small business owners with useful limits to

help them regulate borrowing and spending. Some of the best-known

measures of a company's liquidity include:

Current ratio: Current Assets/Current Liabilities—measures the ability of

an entity to pay its near-term obligations. "Current" usually is defined as

within one year. Though the ideal current ratio depends to some extent on

the type of business, a general rule of thumb is that it should be at least

2:1. A lower current ratio means that the company may not be able to pay

its bills on time, while a higher ratio means that the company has money in

cash or safe investments that could be put to better use in the business.

Quick ratio (or "acid test"): Quick Assets (cash, marketable securities, and

receivables)/Current Liabilities—provides a stricter definition of the

company's ability to make payments on current obligations. Ideally, this

ratio should be 1:1. If it is higher, the company may keep too much cash

on hand or have a poor collection program for accounts receivable. If it is

lower, it may indicate that the company relies too heavily on inventory to

meet its obligations.

Cash to total assets: Cash/Total Assets—measures the portion of a

company's assets held in cash or marketable securities. Although a high

ratio may indicate some degree of safety from a creditor's viewpoint,

excess amounts of cash may be viewed as inefficient.

Sales to receivables (or turnover ratio): Net Sales/Accounts Receivable—

measures the annual turnover of accounts receivable. A high number

reflects a short lapse of time between sales and the collection of cash,

while a low number means collections take longer. Because of seasonal

changes this ratio is likely to vary. As a result, an annual floating average

sales to receivables ratio is most useful in identifying meaningful shifts

and trends.

Days' receivables ratio: 365/Sales to receivables ratio—measures the

average number of days that accounts receivable are outstanding. This

number should be the same or lower than the company's expressed credit

terms. Other ratios can also be converted to days, such as the cost of sales

to payables ratio.

Cost of sales to payables: Cost of Sales/Trade Payables—measures the

annual turnover of accounts payable. Lower numbers tend to indicate good

performance, though the ratio should be close to the industry standard.

Cash turnover: Net Sales/Net Working Capital (current assets less current

liabilities)—reflects the company's ability to finance current operations,

the efficiency of its working capital employment, and the margin of

protection for its creditors. A high cash turnover ratio may leave the

company vulnerable to creditors, while a low ratio may indicate an

inefficient use of working capital. In general, sales five to six times greater
than working capital are needed to maintain a positive cash flow and

finance sales.

LEVERAGE RATIOS
Leverage ratios look at the extent to which a company has depended upon

borrowing to finance its operations. As a result, these ratios are reviewed

closely by bankers and investors. Most leverage ratios compare assets or

net worth with liabilities. A high leverage ratio may increase a company's

exposure to risk and business downturns, but along with this higher risk

also comes the potential for higher returns. Some of the major

measurements of leverage include:

Debt to equity ratio: Debt/Owners' Equity—indicates the relative mix of

the company's investor-supplied capital. A company is generally

considered safer if it has a low debt to equity ratio—that is, a higher

proportion of owner-supplied capital—though a very low ratio can indicate

excessive caution. In general, debt should be between 50 and 80 percent of

equity.

Debt ratio: Debt/Total Assets—measures the portion of a company's

capital that is provided by borrowing. A debt ratio greater than 1.0 means
the company has negative net worth, and is technically bankrupt. This ratio

is similar, and can easily be converted to, the debt to equity ratio.

Fixed to worth ratio: Net Fixed Assets/Tangible Net Worth—indicates

how much of the owner's equity has been invested in fixed assets, i.e.,

plant and equipment. It is important to note that only tangible assets

(physical assets like cash, inventory, property, plant, and equipment) are

included in the calculation, and that they are valued less depreciation.

Creditors usually like to see this ratio very low, but the large-scale leasing

of assets can artificially lower it.

Interest coverage: Earnings before Interest and Taxes/Interest Expense—

indicates how comfortably the company can handle its interest payments.

In general, a higher interest coverage ratio means that the small business is

able to take on additional debt. This ratio is closely examined by bankers

and other creditors.

EFFICIENCY RATIOS
By assessing a company's use of credit, inventory, and assets, efficiency

ratios can help small business owners and managers conduct business

better. These ratios can show how quickly the company is collecting

money for its credit sales or how many times inventory turns over in a
given time period. This information can help management decide whether

the company's credit terms are appropriate and whether its purchasing

efforts are handled in an efficient manner. The following are some of the

main indicators of efficiency:

Annual inventory turnover: Cost of Goods Sold for the Year/Average

Inventory—shows how efficiently the company is managing its

production, warehousing, and distribution of product, considering its

volume of sales. Higher ratios—over six or seven times per year—are

generally thought to be better, although extremely high inventory turnover

may indicate a narrow selection and possibly lost sales. A low inventory

turnover rate, on the other hand, means that the company is paying to keep

a large inventory, and may be overstocking or carrying obsolete items.

Inventory holding period: 365/Annual Inventory Turnover—calculates the

number of days, on average, that elapse between finished goods

production and sale of product.

Inventory to assets ratio Inventory/Total Assets—shows the portion of

assets tied up in inventory. Generally, a lower ratio is considered better.

Accounts receivable turnover Net (credit) Sales/Average Accounts

Receivable—gives a measure of how quickly credit sales are turned into

cash. Alternatively, the reciprocal of this ratio indicates the portion of a

year's credit sales that are outstanding at a particular point in time.

Collection period 365/Accounts Receivable Turnover—measures the

average number of days the company's receivables are outstanding,

between the date of credit sale and collection of cash.

SUMMARY
Although they may seem intimidating at first glance, all of the

aforementioned financial ratios can be derived by simply comparing

numbers that appear on a small busi-ness's income statement and balance

sheet. Small business owners would be well-served by familiarizing

themselves with ratios and their uses as a tracking device for anticipating

changes in operations.

Financial ratios can be an important tool for small business owners and

managers to measure their progress toward reaching company goals, as

well as toward competing with larger companies. Ratio analysis, when

performed regularly over time, can also help small businesses recognize

and adapt to trends affecting their operations. Yet another reason small

business owners need to understand financial ratios is that they provide

one of the main measures of a company's success from the perspective of

bankers, investors, and business analysts. Often, a small business's ability

to obtain debt or equity financing will depend on the company's financial

ratios.

Despite all the positive uses of financial ratios, however, small business

managers are still encouraged to know the limitations of ratios and

approach ratio analysis with a degree of caution. Ratios alone do not make

give one all the information necessary for decision making. But decisions

made without a look at financial ratios, the decision is being made without

all the available data.