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An Introduction to Financial Ratio Analysis
By Michael C. Dennis MBA, CBF

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 norms?

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.

Liquidity Ratios

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 selling inventory.

Leverage Ratios

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.

Efficiency Ratios

  • 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.

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