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- Business: Financial & Investment Data
- BUS 431/533: Financial Markets and Institutions: Company Research
- Almanac of Business and Industrial Financial Ratios
Business: Financial & Investment Data
Some of the names—"common size ratios" and "liquidity ratios," for example—may be unfamiliar. But nothing in the following pages is actually very difficult to calculate or very complicated to use. And the payoff to you can be enormous. The goal of this document is to provide you with some handy ways to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry.
Once you get comfortable with these tools you will be able to turn the raw numbers in your company's financial statements into information that will help you to better manage your business. For most of us, accounting is not the easiest thing in the world to understand, and often the terminology used by accountants is part of the problem.
In fact, it is not. Think of it as "batting averages for business. If you want to compare the ability of two Major League home-run sluggers, you are likely to look at their batting averages.
If one is hitting. In fact, this classic sports statistic is a ratio: it's the number of hits made by the batter, divided by the number of times the player was at bat. For baseball purists, those are "official at-bats," which is total appearances at the plate minus walks, sacrifice plays and any times the player was hit by a pitch. You can think of the batting average as a measure of a baseball player's productivity; it is the ratio of hits made to the total opportunities to make a hit.
Financial ratios measure your company's productivity. There are many ratios you can use, but they all measure how good a job your company is doing in using its assets, generating profits from each dollar of sales, turning over inventory, or whatever aspect of your company's operation that you are evaluating. The use of financial ratios is a time-tested method of analyzing a business. Wall Street investment firms, bank loan officers and knowledgeable business owners all use financial ratio analysis to learn more about a company's current financial health as well as its potential.
Although it may be somewhat unfamiliar to you, financial ratio analysis is neither sophisticated nor complicated. It is nothing more than simple comparisons between specific pieces of information pulled from your company's balance sheet and income statement. A ratio, you will remember from grammar school, is the relationship between two numbers. As your math teacher might have put it, it is "the relative size of two quantities, expressed as the quotient of one divided by the other.
Remember that the ratios you will be calculating are intended simply to show broad trends and thus to help you with your decision-making.
They need only be accurate enough to be useful to you. Don't get bogged down calculating ratios to more than one or two decimal places. Any change that is measured in hundredths of a percent will almost certainly have no meaning.
Make sure your math is correct, but don't agonize over it. In these pages, when we present a ratio in the text it will be written out, using the word "to. Common size ratios can be developed from both balance sheet and income statement items.
The phrase "common size ratio" may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total. For example, each of the items on the income statement would be calculated as a percentage of total sales. Divide each line item by total sales, then multiply each one by to turn it into a percentage.
Similarly, items on the balance sheet would be calculated as percentages of total assets or total liabilities plus owner's equity. This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons. To calculate common size ratios from your balance sheet, simply compute every asset category as a percentage of total assets, and every liability account as a percentage of total liabilities plus owners' equity.
In the example for Doobie Company, cash is shown as being 6. This percentage is the result of the following calculation:. Additional information can be developed by adding relevant percentages together, such as the realization that Common size ratios are a simple but powerful way to learn more about your business.
This type of information should be computed and analyzed regularly. As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities. Receivables should not be tying up an undue amount of company assets.
If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action. This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers. As this example illustrates, the point of doing financial ratio analysis is not to collect statistics about your company, but to use those numbers to spot the trends that are affecting your company.
Ask yourself why key ratios are up or down compared to prior periods or to your competitors. The answers to those questions can make an important contribution to your decision-making about the future of your company.
Current ratio analysis is also a very helpful way for you to evaluate how your company uses its cash. Obviously it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you. The balance sheet for the Doobie Company shows that the company can meet current liabilities.
But you may wonder, "How do I know if my current ratio is out of line for my type of business? You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios. See the Resources section at the end of this document. Because financial ratio comparisons are so important for bank loan officers who make loans to businesses, RMA formerly a bankers' trade association, Robert Morris Associates has for many years published a volume called "Annual Statement Studies.
RMA's "Annual Statement Studies" are available in most public and academic libraries, or you may ask your banker to obtain the information you need. It lists financial ratios for hundreds of industries, and is available in academic and public libraries that serve business communities. These and similar publications will give you an industry standard or "benchmark" you can use to compare your firm to others.
The ratios described in this guide, and many others, are included in these publications. While period-to-period comparisons based on your own company's data are helpful, comparing your company's performance with other similar businesses can be even more informative. To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales. This converts the income statement into a powerful analytical tool. Common size ratios allow you to make knowledgeable comparisons with past financial statements for your own company and to assess trends—both positive and negative—in your financial statements.
The gross profit margin and the net profit margin ratios are two common size ratios to which small business owners should pay particular attention. On a common size income statement, these margins appear as the line items "gross profit" and "net profit. This is computed by dividing gross profit by sales and multiplying by to create a percentage.
Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. For example, if profit margins have declined unexpectedly, you probably will want to closely examine all expenses—again, using the common size ratios for expense line items to help you spot significant changes.
Look at the gross profit and net profit margins as a percentage of sales. Compare these percentages with the same items from your income statement of a year ago. Are any fluctuations favorable or not? Do you know why they changed? The two most common liquidity ratios are the current ratio and the quick ratio.
Both are based on balance sheet items. The current ratio is a reflection of financial strength. It is the number of times a company's current assets exceed its current liabilities, which is an indication of the solvency of that business. Using the earlier balance sheet data for the mythical Doobie Company, we can compute the company's current ratio.
This tells the owners of the Doobie Company that current liabilities are covered by current assets 1. The current ratio answers the question, "Does the business have enough current assets to meet the payment schedule of current liabilities, with a margin of safety?
A common rule of thumb is that a "good" current ratio is 2 to 1. Of course, the adequacy of a current ratio will depend on the nature of the business and the character of the current assets and current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory.
That's why a safety margin is needed. A current ratio can be improved by increasing current assets or by decreasing current liabilities.
Steps to accomplish an improvement include:. A high current ratio may mean that cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment. The Quick Ratio is also called the "acid test" ratio. That's because the quick ratio looks only at a company's most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even if adverse conditions occur. Assets considered to be "quick" assets include cash, stocks and bonds, and accounts receivable in other words, all of the current assets on the balance sheet except inventory.
Using the balance sheet data for the Doobie Company, we can compute the quick ratio for the company. In general, quick ratios between 0. So the Doobie Company seems to have an adequate quick ratio. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company.
The inventory turnover ratio measures the number of times inventory "turned over" or was converted into sales during a time period. It is also known as the cost-of-sales to inventory ratio.
It is a good indication of purchasing and production efficiency.
BUS 431/533: Financial Markets and Institutions: Company Research
This books (Almanac of Business & Industrial Financial Ratios) Made by Philip Wilson About Books CCH's Almanac of Business and Industrial.
Almanac of Business and Industrial Financial Ratios
Some of the names—"common size ratios" and "liquidity ratios," for example—may be unfamiliar. But nothing in the following pages is actually very difficult to calculate or very complicated to use. And the payoff to you can be enormous. The goal of this document is to provide you with some handy ways to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry. Once you get comfortable with these tools you will be able to turn the raw numbers in your company's financial statements into information that will help you to better manage your business.
Almanac of Business and Industrial Financial Ratios. Richard Midgley. Business Expert Press. Jessa Mei Diana Mendoza. Shahbaz Rafique Minhas.
The information you will find on a company depends upon several factors. Before you begin your research, ask yourself these questions:.
Author s : Philip Wilson. The comprehensive resource puts 50 comparative performance indicators at the practitioner's command and covers all of North America U. The Almanac provides financial information that is calculated and derived from the latest available IRS data on nearly 5 million U. The Almanac gives you accurate performance data for 50 operating and financial factors in industries. Data for each industry is divided into 13 categories based on company size, so you'll find a precise benchmark against which to measure any company's performance. One quick glance at the appropriate field of business and company-size category and you've found the definitive starting point for competitive performance analysis.
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