An Introduction to Financial Ratio Analysis
By Michael C. Dennis MBA,
Financial ratio analysis is a useful technique
to measure, compare, and evaluate the financial condition
and performance of a customer. Ratio analysis enables a credit
manager to spot trends in a customer's financial performance,
and to compare its performance and financial condition with
the average performance of similar businesses in the same
industry. Balance sheet ratios measure liquidity and solvency
(a business's ability to pay its bills as they come due)
and leverage (the extent to which the business is dependent
Financial ratio analysis is used by credit
professionals to answer these questions about customers:
Is the business profitable?
Can the business pay its bills on time?
How is the business financed?
How does the company financial performance this year compare
to last year?
How does the customer's performance compare with its competitors?
How does the customer's performance compare to the industry
Financial ratio analysis is a useful tool for determining
a customer's overall financial condition. Industry-wide financial
ratios are published by a variety of sources, including Dun & Bradstreet.
Financial ratios are useful for making quick comparisons. Banks
and trade creditors use financial ratio analysis to help them
decide whether a business is a good credit risk or not.
Ratio analysis is a tool to help evaluate the overall
financial condition of a customer's business. Ratios are useful
for making comparisons between a customer and other businesses
in an industry. A financial ratio is a simple mathematical comparison
of two or more entries from a company's financial statements.
Creditors use ratios to chart a company's progress, uncover trends
and point to potential problem areas.
These ratios indicate the ease of turning assets
into cash. Liquidity refers a company's ability to meet current
obligations with cash or other assets that can be quickly converted
to cash. Liquidity Ratios give an indication of a company's short
term financial or solvency. They include the Current Ratio, Quick
Ratio, and Working Capital.
The Current Ratio formula is: Current assets
divided by current liabilities. The current ratio is one
of the best-known measures of financial liquidity. The current
ratio is the standard measure of any business' financial
health. It will tell you whether a customer is able to meet
its current obligations by measuring if it has enough assets
to cover its liabilities.
The Quick Ratio formula is: (Current assets
less inventories) divided by current liabilities. The quick
ratio (also sometimes called the acid test ratio) measures
a customer's liquidity. The quick ratio is more 'strenuous'
than the current ratio because it attempts to answer the
question of whether current liabilities could be paid without
Leverage ratios measure the relative contribution
of stockholders and creditors. Leverage ratio indicates the extent
to which the business is reliant on debt financing (creditor
money versus owner's equity). Leverage Ratios which show the
extent that debt is used in a company's capital structure
The Debt to Equity ratio formula is: Total
liabilities divided by total equity. This ratio indicates
how much the company is leveraged (in debt) by comparing
what is owed to what is owned. A high debt to equity ratio
could indicate that the debtor company may be over-leveraged
[too reliant on debt as a source of funding] and should look
for ways to reduce its debt.
The Interest Coverage Ratio formula is: Earnings
before Interest, Taxes, Depreciation and Amortization divided
by Interest Expense. This ratio indicates what portion of
debt interest is covered by a company's cash flow situation.
· Profitability Ratios
· Profitability refers to a company's ability to generate revenues in
excess of the costs incurred in producing those revenues.
The Gross Profit Margin formula is: Gross
Profit divided by Total Sales. The gross profit margin ratio
indicates how efficiently a business is using its materials
and labor in the production process.
The Return on Sales formula is: Net profit
divided by sales. This ratio compares after tax profit to
sales. It can help you determine if you are making an adequate
return on sales.
The Return on Assets formula is: Net Income
divided by Average Total Assets. The higher the percentage
rate that a company has the better.
The Inventory Turnover Ratio formula is: Cost
of goods sold divided by average inventory. In general, the
higher the turnover ratio the better the company is performing
and the less likely it is that your customer has a lot of
obsolete and slow moving inventory that sooner or later will
need to be disposed of at a loss.
The Asset Turnover formula is: Net sales divided
by average total assets. Asset turnover is an indicator of
how efficiently a firm utilizes its assets to generate sales
and profits. If the ratio is high, it implies that the firm
is using its assets efficiently.