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Ratio analysis tools meansure your business

Ratio Analysis
Tools to measure your
Part TWO
BUS 203 Bus Fin Mgt _ RATI
Spring 2006

What is Ratio Analysis
• A tool to measure the
progress of your business
and to compare with the
• Ratios measure
proportions or relationships.
• Ratios allow you to make
comparisons with your own
history and the competition.

Using Ratios without Fear
• Think of a ratio as a friend 
• Ratios are simple to calculate
(especially with a calculator).

• Ratios DO NOT take the
place of good management.
• They are tools to point out
areas that need more

Basic Fraction Review
• When comparing a part to
a whole the whole is
always the base.
net profit

• A percentage can increase
by more than 100% (but it
cannot decrease by more
than 100%).

Rules for Ratios
• Maintain an Objective Attitude
(don’t use them to predetermine, use them
to have a better understanding).

• Compare apples with apples and
oranges with oranges: same size
and type of business. Hint: Use
industry standards.
• Don’t use meaningless numbers.
• Avoid using the wrong figures.

Types of Ratios
• Liquidity - liquidity ratios help you

determine your ability to pay debt.

• Profitability - measures your ability to
make a profit.

• Efficiency or Activity - shows how
well you are conducting business.

• Leverage or Debt - refers to the degree
to which a firm relies on borrowed funds in
its operations.

Liquidity Ratios:

Measures Your Ability to Pay
Short-Term Debt

• Current Ratio – current assets /
current liabilities…the Current Ratio
should be 2x liabilities or 200%

• Quick Ratio or “Acid Test” Same as Current Ratio, but it doesn’t’
include inventories (so only cash and a/r
are counted)

• Turnover of Cash or “Working
Capital” sales / working capital
Shows your ability to handle cash flow in
the business (working capital is CA-CL)

Current, Quick Ratios & Working Capital :
What the Banker looks at first.
• A “low” ratio could indicate that the company
cannot pay its bills.
• A “high ratio” could indicate that there is a lot of
money tied up in cash or securities.
• The banker will compare the business to other like
• A “safe” Quick Ratio is at least 1.0 times the current
liabilities. This shows that inventory is being
• For Working Capital - sales should be 5 or 6 times
the working capital (depending on the business).
• Some of this information you can find on the
Balance Sheet and some on the Income

Profitability or Performance Ratio Tools
• Profitability is WHY we are in business!
• We want a better Return on Our Money
or ROI (return on investment).
• Profitability measures how effective we
are at using our various resources to
achieve profit.
• Large businesses use profitability
measures to show management
• As a general rule, profitability comes
from changes in price or volume.

Profitability Ratios Commonly Used
• Net Profit Ratio =
Earnings Before Taxes / Net Sales

• Rate of Return on Sales – how much net
profit was derived from every dollar of

• ROI - Return on Investment =
EBT / Net Worth

• Return on Assets =
Net Profit / Total Assets

Efficiency or Activity Ratio Tools
• Show us how efficient you are at
collecting your money and how
good you are at turning over
• Efficiency Ratios help keep your
business in balance.
• They often highlight management
skills and are keenly viewed by
• Efficiency ratios determine if you
can handle growth.

Common Efficiency Ratios:
Average Collection Period
• Average Collection Period determines the number of average
days it takes you to collect your
AR x 365/ Sales
• The accepted standards depend
on your industry norm, and your
credit policy.
• A high ratio could indicate a
number of bad accounts, or poor
collection practices.

Efficiency Ratios: Inventory Turnover
• A tool to measure how fast you are
moving your inventory.
COGS / Average Inventory
• Depending on your industry, you want to
turn your “stock” 6 times per year.
• A slow inventory turnover could mean
you have the “wrong” stock or you are
carrying too much.
• Fast inventory turn-over increases cash

Debt Ratios
The Debt to Owner’s Equity Ratio
Measures the degree to which the
company is financed by funds that must
be repaid.
Bankers have benchmarks that they will
look at before considering offering a
A ratio of above 1 or 100% would show
that a firm has more debt than equity.
Lower ratios show greater long-term
financial safety.

Total Liabilities /
Owner’s Equity

Using a Comparison Chart can
help a manager to..
• Compare your historical progress
• Compare your self to the industry
(Check out RMA or your trade
association for industry standards)
• Plan for seasonality
• Plan for future expansion
• Control Management - inventory
and cash flow
• Make sure you are on the right

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