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Financial Ratios

Our work with clients requires some familiarity with financial ratios. You may find the following brief discussions of various ratios helpful.

SEE THE RISK RISK RETENTION  SECTION TO ASSIST IN YOUR UNDERSTANDING OF THE APPLICATION OF THESE RATIOS.  THIS MAY NOT BE FOR THE FINANCIALLY FAINT OF HEART, BUT IT SHOULD GIVE YOU SOME IDEA OF THE CARE WITH WHICH WE ANALYZE AND ASSESS OUR CLIENTS RISKS .

A. LIQUIDITY RATIOS

Liquidity is a measure of the quality and adequacy of current assets to meet current obligations as they come due.

1. QUICK RATIO

Computation: Cash and equivalents plus accounts and notes receivable (trade) divided by total current liabilities.

  • Cash & Equivalents + Accounts
    & Notes Receivable (trade)
  • Total Current Liabilities
    • = (?) : 1

Interpretation: Also known as the “acid test” ratio, it is a refinement of the current ratio and is a more conservative measure of liquidity. The ratio expresses the degree to which a company’s current liabilities are covered by the most liquid current assets. Generally, any value of less than one to one implies a reciprocal dependency on inventory or other current assets to liquidate short-term debt.

2. CURRENT RATIO

Computation: Total current assets divided by total current liabilities.

  • Total Current Assets
  • Total Current Liabilities
    • = (?) : 1

Interpretation: This ratio is a rough indication of a firm’s ability to serve its current obligations. Generally, the higher the current ratio, the greater the “cushion” between current obligations and a firm’s ability to pay them. The stronger ratio reflects a numerical superiority of current assets over current liabilities. However, the composition and quality of current assets is a critical factor in the analysis of a firm’s liquidity.

3. SALES/RECEIVABLES RATIO

Computation: Net sales divided by accounts and notes receivable (trade).

  • Net Sales
  • Total Current Liabilities
    • = (?) : 1

Interpretation: This ratio measures the number of times accounts and notes receivable (trade) turn over during the year. The higher the turnover of receivables, the shorter the time between sale and cash collection. For example, a company with sales of $720,000 and receivables of $120,000 would have a sales/receivables ratio of 6:1, which means receivables turn over six times a year. If a company’s receivables appear to be turning slower than the rest of the industry, further research is needed and the quality of the receivables should be examined closely

4. SALES/WORKING CAPITAL RATIO

Computation: Net sales divided by net working capital (current assets less current liabilities equals net working capital).

  • Net Sales
  • Net Working Capital
    • = (?) : 1

Interpretation: Working capital is a measure of the margin of protection for current creditors. It reflects the ability to finance current operations. Relating the level of sales arising from operations to the underlying working capital measures how efficiently working capital is employed. A low ratio may indicate an inefficient use of working capital while a very high ratio often signifies overtrading – a vulnerable position for creditors.

B. LEVERAGE RATIOS

Highly leveraged firms (those with heavy debt in relation to. net worth) are more vulnerable to business downturns than those with lower debt to worth positions. While leverage ratios help to measure this vulnerability, remember that they vary greatly depending on the requirements of particular industry groups.

1. FIXED/WORTH RATIO

Computation: Fixed assets (net of accumulated depreciation) divided by tangible net worth.

  • Net Fixed Assets
  • Total Tangible Worth
    • = (?) : 1

Interpretation: This ratio measures the extent to which owner’s equity (capital) has been invested in plant and equipment (fixed assets). A lower ratio indicates a proportionately smaller investment in fixed assets in relation to net worth, and a better “cushion” for creditors in case of liquidation. Similarly, a higher ratio would indicate the opposite situation. The presence of substantial leased, fixed assets (not shown on the balance sheet) may deceptively lower this ratio.
2. DEBT/WORTH RATIO

Computation: Total liabilities divided by tangible net worth.

  • Total Liabilities
  • Tangible Net Worth
    • = (?) : 1

Interpretation: This ratio expresses the relationship between capital contributed by creditors and that contributed by owners. It expresses the degree of protection provided by the owners for the creditors. The higher the ratio, the greater the risk being assumed by creditors. A lower ratio generally indicates greater long-term financial safety. A firm with a low debt/worth ratio usually has greater flexibility to borrow in the future. A more highly leveraged company has a more limited debt capacity.

 

C. OPERATING RATIOS

Operating ratios are designed to assist in the evaluation of management performance.

 

1. PERCENT PROFITS BEFORE TAXES/TANGIBLE NET WORTH RATIO

Computation: Profit before taxes divided by tangible net worth and multiplied by 100.

  • Profit before Taxes
  • Tangible Net Worth
    • X 100
    • = (?) : 1

Interpretation: This ratio expresses the rate of return on tangible capital employed. While it can serve as an indicator of management performance, use it in conjunction with other ratios. A high return, normally associated with effective management, could indicate an undercapitalized firm. A low return, usually an indicator of inefficient management performance, could reflect a highly capitalized, conservatively operated business.

 

2. PERCENT PROFIT BEFORE TAXES/ASSETS RATIO

Computation: Profit before taxes divided by total assets and multiplied by 100.

  • Profit before Taxes
  • Total Assets
    • X 100
    • = (?) : 1

Interpretation: This ratio expresses the pretax return on total assets and measures the effectiveness of management in employing the resources available to it. If a specific ratio varies considerably from expected ranges you will need to examine the makeup of the assets and take a closer look at the earnings figure. A heavily depreciated plant and a large amount of intangible assets or unusual income or expense items will cause distortions of this ratio.

See the Risk Retention Section for practical application of these ratios