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January 28, 2019

Using Financial Ratios to Evaluate Financial Strength (or Weakness) – Part 1

Determining a company’s successful performance or identifying its risks involves more than just acctexamining the cash balance in the checkbook or “the bottom line” on the Income Statement.  While analyzing complex financial information can be challenging, financial ratios can provide business owners with excellent tools and useful indicators of their company’s financial strength (or weakness).

Financial ratios are the most common and widespread tools used to analyze a business’ financial standing. 

They are easy to understand, simple to compute, and are used to compare performance from year to year as well as to industry averages.  Financial ratios are mathematical comparisons of financial statement accounts or categories and are classified according to the information they provide.  There are six main groups of ratios:

  1. Liquidity
  2. Solvency (or Leverage)
  3. Efficiency
  4. Profitability
  5. Market Prospect
  6. Coverage

    This month, we will examine the first three groups:

LIQUIDITY RATIOS

Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current.  In other words, these ratios show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.  Liquidity is not only a measure of how much cash a business has.  It is also a measure of how easy it is for a company to raise enough cash or convert assets into cash.  Assets like accounts receivable, trading securities, and inventory are relatively easy for many companies to convert into cash in the short term.  Thus, all of these assets go into the liquidity calculation of a company.

Here are the most common liquidity ratios, how they are calculated, and their definitions.

Name

Calculated as

Definition

Current Ratio (also known as Working Capital Ratio)

Current Assets divided by Current Liabilities

Indicates the extent to which current assets are available to satisfy current liabilities.  Expressed as an absolute value (for example, 2.5), the higher the ratio the better, as it demonstrates the ease with which current debts can be paid.

Quick Ratio[1]

(Cash and Cash Equivalents + Short-Term Investments + Net Receivables) divided by Current Liabilities

Quick assets are current assets that can be converted to cash within 90 days to satisfy current liabilities.  Also expressed as an absolute value, a Quick Ratio of 1.0 is generally considered a liquid position.

Days of Cash

((Cash and Cash Equivalents) times 360) divided by Revenue

Indicates the number of days’ revenue in cash.  Generally, a ratio of 7 days or more is considered adequate.

Working Capital Turnover

Revenue divided by (Current Assets minus Current Liabilities)

Indicates the amount of revenue being supported by each dollar of net working capital (current assets minus current liabilities).  A ratio exceeding 30 may indicate a need for more working capital to support future revenue growth.

 

[1] Sometimes company financial statements don’t give a breakdown of quick assets on the balance sheet.  In this case, the quick ratio can be calculated even if some of the quick asset totals are unknown.  Simply subtract inventory and any current prepaid assets from the current asset total for the numerator of the fraction.

SOLVENCY (LEVERAGE) RATIOS

Solvency ratios, also called leverage ratios, measure a company’s ability to sustain operations indefinitely by comparing debt levels with equity, assets, and earnings.  In other words, solvency ratios identify going concern issues and a firm’s ability to pay its bills in the long term.  Many people confuse solvency ratios with liquidity ratios. Although they both measure the ability of a company to pay off its obligations, solvency ratios focus more on the long-term sustainability of a company instead of the current liability payments.  Solvency ratios show a company’s ability to make payments and pay off its long-term obligations to creditors, bondholders, and banks.  Better solvency ratios indicate a more creditworthy and financially sound company in the long-term.

 

Here are the most common solvency (leverage) ratios, how they are calculated, and their definitions.

Name

Calculated as

Definition

Debt to Equity

Total Liabilities divide by Total Net Worth (Equity)

Shows the percentage of company financing that comes from creditors and investors.  A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).  Generally, a ratio of 3 or less is considered acceptable.

Revenue to Equity

Revenue divide by Total Net Worth (Equity)

Indicates the level of revenue being supported by each dollar of equity.  Generally, a ratio of 15 or less is considered acceptable.

Fixed Asset

Net Fixed Assets divided by Total Net Worth (Equity)

Indicates the level of stockholders’ equity invested in net fixed assets.  A higher ratio may indicate a lack of funds for current operations.  A low ratio is desirable here.

Equity to General & Administrative (Overhead) Expenses

Total Net Worth (Equity) divided by G&A (Overhead) Expenses

Indicates the level of overhead in relation to net worth. Generally, a ratio of 1.0 or more is considered acceptable.

Underbillings to Equity

(Unbilled Work plus Costs in Excess of Billing) divided by Total Net Worth (Equity)

Indicates the level of unbilled contract volume being financed by stockholders.  Usually stated as a percentage, a ratio of 30% or less is considered acceptable

Backlog to Equity

Backlog divided by Total Net Worth (Equity)

Shows the amount of signed/committed work to total stockholders’ equity.  Generally, a ratio of 20 or less is considered acceptable.  A higher ratio may indicate a need for additional permanent equity.

 

EFFICIENCY RATIOS

Efficiency ratios, also called activity ratios, measure how well companies utilize their assets to generate income.  Efficiency ratios often look at the time it takes companies to collect cash from customer or the time it takes companies to convert inventory into cash—in other words, make sales.  These ratios are used by lenders in setting loan covenant guidelines.

 

Here are the most common efficiency ratios, how they are calculated, and their definitions.

Name

Calculated as

Definition

Months in Backlog

Backlog divided by (Revenue divided by 12)

Indicated the average number of months it will take to complete all signed/committed work.

Days in Accounts Receivable

(Accounts Receivable plus Retainage Receivable minus Allowance for Uncollectables) times 360 divided by Revenue

Indicates the number of days it takes to collect customer receivables.  The lower the ratio the better the liquidity.

Days in Inventory

Inventory times 360 divided by Cost of Sales

Indicates the number of days required to sell inventory.  A high ratio may indicate overstocking of inventory.

Days in Accounts Payable

(Accounts Payable plus Retainage Payable) times 360 divided by Total Cost

Indicates the number of days it takes to liquidate trade payables.  While a high ratio may cause suppliers to label the company as a “bad client” and impose credit restrictions, a low DPO may indicate that the company is not fully utilizing its cash position and may indicate an inefficiently operating company.

Operating Cycle

Days in Cash[2] plus Days in Accounts Receivable plus Days in Inventory minus Days in Accounts Payable

The operating cycle is the time required for a company's cash to be put into its operations and then return to the company's cash account.  A low ratio may indicate a need for more permanent working capital.

 

In summary, ratio analyses can identify your company’s strengths and weaknesses, especially after you calculate results for your last two or three fiscal years.  Look for trends and then implement processes/procedures to fix the weaknesses.

Next month, we’ll discuss the other 3 categories of ratios:  Profitability, Market Prospect, and Coverage.

[2] Cash on hand ÷ ((Operating expenses - Noncash expenses) ÷ 365)

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