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Ratio Analysis - Start-up Issues, Entrepreneurship & Small Businesses Notes | Study Entrepreneurship & Small Businesses - B Com

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One method of financial analysis commonly used is ratio analysis. A variety of ratios can be calculated to help monitor the financial status of the business. As well, by comparing your ratios to industry averages you can get a better idea of how you are faring relative to others in your particular business. Careful ratio analysis will help pinpoint problem areas.

Industry averages for the five ratios explained below, as well as for a number of other such as gross margin, profits on sales, sales to inventory, are published regularly by Dun and Bradstreet and other services. These publications are available for perusal at good Govt. Business resources such as in Winnipeg

1 Current Ratio
The current ratio measures the liquid assets available to meet all debts falling due within one year’s time. The higher the current ratio, the greater the ability of the firm to pay its bills.

Current Assets = current ratio
Current liabilities

For instance, if you had a current ratio of 1.5 this would mean you debts could be paid one and a half times by current assets

2 Quick Ratio
The quick ratio (or the quick asset ratio) is similar to the current ratio in that all current assets are taken into account less inventories

Current Assets - Inventories = current ratio
Current liabilities

This ratio can be interpreted in the same way as the current ratio. The only difference lies in the fact that inventories are excluded. In other words, inventory is probably less liquid than other current assets, therefore the quick ratio should provide a better picture as to a firm’s ability to meet its short-term debts than the current ratio would.

3 Average Collection Period ratio
The average collection period ratio shows how long the money in a business is tied up in credit sales.

Accounts and notes receivable x days in year  = days
Annual credits sales

If, for example the ratio came out to 60 days, and the terms are that the final due date is 30 days, the typical receivable is being collected 30 days after the due date. Since sizeable portion of the receivables are being paid after the due date, the credit policy of the company should be investigate.

Inventory Turnover Ratio
The inventory turnover ratio give an indication of the efficiency of the inventory management of the company. Care must be exercised in interpreting this ratio, since a high ratio may indicate either a  high level of efficiency or too low a level of inventory (i.e. frequently stock outs ). A low ratio indicates slow-moving inventory which may result in obsolescence.

Cost of Goods Sold    = Inventory Turnover Ratio
Average Inventory

Average Inventory = Beginning Inventory + ending Inventory / 2

If the turnover ratio turned out to be 2, this would mean that the company sells the total stock of goods twice in one period. Depending on the industry average, a comparison will show a whether the ratio is or is not in line.

Turnover Of Working Capital Ratio
The turnover of working capital ratio measures how actively working capital in a business is functioning in terms of sales. Working capital is assets that can be converted into operating funds within a year (or working capital = currents – current liabilities).

Net assets              = Turnover of Working Capital
Working Capital

A low ratio usually means that working capital is not being used efficiently, while a high ratio suggests vulnerability to creditors. Comparison to industry average should provide insight as to what the ratio should be.

6 Debt to Equity
The debt to equity ratio indicates the investment of the lender in relation to the investment of the owners.

Debt         = Debt to equity
Equity

A high ratio indicates that the business is financed mostly through borrowed funds, whereas a low ratio indicates that the owners have invested a larger amount required to finance the business

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