Hooray for Ratios: The analysis paralysis of financial statements

March 12, 2009 · Filed Under Bookkeeper, Bookkeeping, Bookkeeping Process, Bookkeeping Support Services, Bookkeeping Theory 

Analyzing your company’s performance is crucial to making determinations surrounding your investment activities. The objectives you define are generally based on your company’s current and past financial performance. If you’ve ever heard of benchmarks, then you know that the results you determine from your analysis are useless unless you have something to compare them too. Analyzing your company’s financial activities involves using specific methods of investigation. Ratio analysis involves studying the relationship between two or more items on your financial statements. With ratio analysis you’ll be able to make key financial decisions such as; which areas need improvement, which areas are profitable, are you meeting your cash requirements, and are you meeting your obligations. The most common of these analysis are:

Current Ratio
Inventory turnover Ratio
Profit margin on sales
Days sales outstanding ratio
Debt to total assets ratio
Current Ratio

This ratio determines is a company is able to meet its current obligations. In other words, are you able to pay off your current liabilities? Typically a current ratio of 2:1 states that a company is able to meet its current obligations. Also known as the Quick Ratio, it is calculated by dividing current assets by current liabilities.

Inventory Turnover Ratio
This ratio evaluates your inventory and states how many time in a year your inventory is sold or replaced. A low ratio would imply that a company has excess inventory on hand. For example, if a company has an inventory ratio of 6.3, this would mean that inventory would have to be restocked at least 6 times in a year. In this example, sales are good because your products are moving. This ratio is calculated by dividing Cost of Goods sold by the average inventory. The average inventory is calculated by adding the beginning and ending inventory balances and dividing this total by two.

Profit Margin on Sales
This ratio determines how profitable a company has been. It is calculated by dividing the Net Profit for the year by total sales. When compared with prior periods, this ratio is revealing in that shows whether a firm is operating efficiently and able to compete successfully with its competitors. For example: if your net profit is 1,000,00 and your sales are 15,000,000,then your profit margin would be 6.67%. This means that for every dollar of sales, your company made .06 cents profit. When calculating this ratio be sure to reflect net profit which deducts cost of goods sold along with operating expenses.

Days sales outstanding ratio
Based on daily sales activity, this ratio determines how long it takes to get paid after making a sale. It is calculated by dividing the accounts receivable by the average sales per day. It’s important to monitor this ratio closely as it directly affects your cash flow.

Debt to total assets ratio
This ratio represents the total debt as a percentage of total assets. It is calculated by dividing total liabilities by total assets. A low ratio indicates that a company is more likely able to pay its creditors with a reduction in assets, whereas a higher ratio would mean that it would hurt the company to reduce its assets in order to make its payables.

There exist over 20 various ratios that company’s can use to examine and evaluate their financial standing. Using ratio analysis allows you to make decisions concerning credit, management style, and whether the processes chosen are effective in accomplishing the company’s goals.

Partnering for your success
Jacqueline Williams
Financial Strategist

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