9.4: Classes of Ratios

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios are useful to managers within a firm, to current and potential shareholders (owners) of a firm, and to a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company trade in a financial market, the market price of the shares is useful in certain financial ratios.

Ratios are useful to examine and display the ‘liquidity’ or amount of cash, accounts receivable, or other forms of assets that can be converted to cash quickly if the need arises. In the restaurant industry, how quickly or slowly the perishable food, paper, and other items we stock is used are replenished is always of major concern to the operation. The ‘turnover’ rate calculation occurring weekly, monthly, or quarterly, is indicative of how well we are projecting the restaurant’s product demand, and how well we are controlling storage costs and physical space allocations. Solvency ratios examine the status assets and liabilities, and profitability ratios give us a way to discuss and display how well the operation is conducting business. The basic ‘four’ different classes of ratios we will discuss are:

1. Liquidity
2. Turnover
3. Solvency
4. Profitability

We should first define the term ‘ratio’. In mathematics, a ratio is a relationship between two numbers indicating how many times the first number contains the second. For example, if a bowl of fruit contains ‘eight’ oranges and ‘six’ lemons, then the ratio of oranges to lemons is eight to six (that is, 8:6, which is equivalent to the ratio 4:3). Thus, a ratio can also be a fraction as opposed to a whole number. In addition, in this example the ratio of lemons to oranges is 6:8 (or 3:4), and the ratio of oranges to the total amount of fruit is 8:14 (or 4:7). The numbers compared in a ratio can be any quantities of a comparable kind, such as objects, persons, lengths, or spoonful amounts. A ratio is written "a to b" or ‘a : b’ or sometimes expressed arithmetically as a ‘quotient’ of the two.

Liquidity Ratios

The current ratio is a liquidity ratio that measures whether or not a firm has enough resources to meet its short-term obligations. It compares a firm's current assets to its current liabilities. The current ratio is an indication of a firm's liquidity. Acceptable current ratios vary from industry to industry. In many cases, a creditor would consider a high current ratio to be better than a low current ratio, because a high current ratio indicates that the company is more likely to pay the creditor back. Large current ratios are not always a good sign for investors. If the company's current ratio calculates too high it may indicate that, the company is not efficiently using its current assets or its short-term financing facilities.

Current Ratio = Current Assets / Current Liabilities
Example: $2,600,000 / $2,500,000 = 1.04

If current liabilities exceed current assets, the ‘current ratio’ will be less than one. A current ratio of less than ‘1’ indicates that the company may have problems meeting its short-term obligations. Some types of businesses can operate with a current ratio of less than one however. If inventory turns into cash much more rapidly than the accounts payable become due, then the firm's current ratio can comfortably remain less than one. Inventory is valued at the cost of acquiring it and the firm intends to sell the inventory for more than this cost. The sale will therefore generate substantially more cash than the value of inventory on the balance sheet. Low current ratios can also be justified for businesses that can collect cash from customers long before they need to pay their suppliers.

The ‘acid test’ or ‘quick ratio’ or ‘liquidity ratio’ measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can quickly convert to cash at close to their book values. A company with a quick ratio of less than ‘one’ cannot currently fully pay back its current liabilities. It is the ratio between quick or liquid assets and current liabilities. The normal liquid ratio is 1:1. It has a better and more reliable ranking as a tool for assessment of liquidity position of firms.

Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Example: $2,600,000 - $150,000 -$50,000 = .96

Working capital (abbreviated WC) is a financial metric, which represents operating liquidity available to a business, organization or other entity, including governmental entity. Working capital is the difference between the current assets and the current liabilities. Along with fixed assets such as plant and equipment, working capital is a part of operating capital. Gross working capital equals to current assets. Working capital calculation is ‘current assets’ minus ‘current liabilities’. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

Working Capital = Current Assets – Current Liabilities
Example: $2,600,000 -$2,500,000 = $100,000

A company can be possess with ‘assets’ and ‘profitability’ but be short of ‘liquidity’ if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. The basic calculation of the working capital utilizes the ‘gross current assets’ of the firm.

Current assets and current liabilities include three accounts that are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

1. Accounts receivables (current asset)
2. Inventory (current assets), and
3. Accounts payable (current liability)

The current portion of ‘debt’ (payable within 12 months) is critical, because it represents a short-term claim to current assets and often uses long-term assets as security. Common types of short-term debt are bank loans and lines of credit. An increase in net working capital indicates that the business has either increased current assets (that it has increased its receivables or other current assets) or has decreased current liabilities - for example has paid off some short-term creditors, or a combination of both.

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize ‘free cash flow’. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30-day cycle usually needs funding through a bank operating line, and the interest on this financing is a carrying cost that reduces the company's profitability. Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow. Sophisticated buyers review closely a target's working capital cycle because it provides them with an idea of the management's effectiveness at managing their balance sheet and generating free cash flows.

As an absolute rule of funders, each of them wants to see a positive working capital. Such situation gives them the possibility to think that your company has more than enough current assets to cover financial obligations. The same is not always true about negative working capital. A large number of funders believe that businesses cannot be sustainable with a negative working capital, which is a wrong way of thinking. In order to run a sustainable business with a negative working capital it is essential to understand some key components.

Approach your suppliers and persuade them to let you purchase the inventory on 1-2 month credit terms, but keep in mind that you must sell the purchased goods, to consumers for money. Effectively monitor your inventory management, make sure that refilling occurs on a consistent and timely basis to maintain fresh product with the help of your supplier, and to adequately stock and utilize your warehouse spacing.

In addition, big companies like McDonald’s, Amazon, Dell, General Electric and Wal-Mart are using negative working capital.

Activity Ratios

Inventory Turnover = Cost of Goods Sold / Inventories
Example: $500,000 / $110,000 = 4.55 times
Average Inventory = beginning inventory + Ending inventory
2

The average days to sell the inventory calculation is:

Average days to sell the inventory = ________365_________
Inventory Turnover Ratio

In accounting, the Inventory turnover is a measure of the number of times the restaurant’s sells or uses its inventory using a week, month or year calculation. The equation for inventory turnover equals the cost of goods sold or net sales divided by the average inventory. Inventory turnover is also known as: inventory turns; merchandise turnover; stock turn; turns, and stock turnover.

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.

Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business, as the inventory is too low. This often can result in stock shortages. Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of cost of sales. ‘Cost of sales’ yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. Cost of sales is more realistic because of the difference in which one records sales and the cost of sales. Record sales at market value, i.e. the value at which the marketplace paid for the good or service provided by the firm. In the event that the firm had an exceptional year and the market paid a premium for the firm's goods and services then the numerator may be an inaccurate measure. However, the firm should record cost of sales at what the firm actually paid for the materials available for sale.

Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. Generally, the terms "cost of sales" and "cost of goods sold" are synonymous. An item whose inventory is sold (turns over) once a year has higher holding cost than one that turns over twice, or three times, or more in that time. Stock turnover also indicates the briskness of the business. The purpose of increasing inventory turns is to reduce inventory for three reasons.

1. Increasing inventory turns reduces holding cost. The organization spends less money on rent, utilities, insurance, theft and other costs of maintaining a stock of good for sale. Reducing holding cost increases net income and profitability as long as the revenue from selling the item remains constant.
2. Items that turn over more quickly increase responsiveness to changes in customer requirements while allowing the replacement of perishable items. This is a major concern in the restaurant industry.
3. When making comparison between firms, it is important to take note of the industry, or distortion in the comparison will occur. Making comparison between a supermarket or restaurant and a car dealer will not be appropriate, as supermarkets and restaurants sell fast-moving goods such as meals, sweets, chocolates, soft drinks therefore the stock turnover will be higher. However, a car dealer will have a low turnover due to the item being a slow moving item.

Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. Companies in the retail industry tend to have a very high turnover ratio due mainly to cutthroat and competitive pricing.

‘Sales’ is the value of ‘Net Sales’ or ‘Sales’ from the company's income statement ‘Average Total Assets’ is the average of the values of ‘Total assets’ from the company's balance sheet in the beginning and the end of the fiscal period. The calculation adds up the assets at the beginning of the period and the assets at the end of the period, then dividing that number by two. Alternatively, "Average Total Assets" can be ending total assets.

Asset Turnover = Sales / Total Assets
Example: $4,805,000 / $9,225,000 = .52 times (generating .52 cents per dollar)

Fixed-asset turnover is the ratio of ‘sales’ (on the profit and loss account) to the value of ‘fixed assets’ (on the balance sheet). It indicates how well the business is using its fixed assets to generate sales. In general, the higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.

Fixed Asset turnover = Sales / Fixed assets
Example: $4,805,000 / $6,500,000 = .74 times (generating .74 cents per dollar)

This calculation allows the operator to know what the total revenue per hour would be will a ‘full’ dining room at a given average ticket price. It is the ‘optimum’ calculation. Example: If the restaurant has 150 seats, an average ticket price for lunch of $15.00, and a one- hour turnover, the total revenue potential would be $2,250.00 per hour. The total revenue potential for lunch then centers on the number of hours the restaurant serves lunch.

REV Pash (revenue per avg. seating hour) = Total Occupancy x Average ticket price per hour.

This calculation is the point of comparison to the ‘REVPash’ total occupancy calculation. The dining room may not be full which would reduce the revenue for the meal period. In essence, you are calculating real income and comparing that figure to ‘optimum’ income to assess your current potential.

REV Posh (revenue per occupied seating hour) = Occupancy rate x Average ticket price per hour.

Average food check = Food Revenue / Number of customers

Solvency Ratios

For example, a company with $2 million in total assets and $500,000 in total liabilities would have a debt ratio of 25% (percentage of assets financed). Total liabilities divided by total assets or the debt/asset ratio shows the proportion of a company's assets which are financed through debt. If the ratio is less than 0.5, most of the company's assets are using equity financing. If the ratio is greater than 0.5, most of the company's assets are using debt to finance. Companies with high debt/asset ratios are ‘highly leveraged’ by description. The higher the ratio, the greater risk will be associated with the firm's operation. In addition, high debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the firm's financial flexibility. Like all financial ratios, a company's ‘debt ratio’ should use industry average or other competing firms as their points of comparison.

Debt to Assets Ratio = Total liabilities / Total assets

In a general sense, the ratio is simply debt divided by equity. However, what receives a ‘debt’ classification can differ depending on the interpretation used. Thus, the ratio can take on a number of forms including:

• Debt / Equity
• Long-term Debt / Equity
• Total Liabilities / Equity

In a basic sense, ‘Total debt to Equity’ is a measure of all of a company's future obligations on the balance sheet relative to equity. However, the ratio can be more discerning as to what is actually a borrowing, as opposed to other types of obligations that might exist on the balance sheet under the liabilities section. For example, often only the liabilities accounts that the operation labels as actually labeled as "debt" on the balance sheet appear in the numerator, instead of the broader category of "total liabilities". In other words, actual borrowings uses bank loans and interest-bearing debt securities, as opposed to the broadly inclusive category of total liabilities that, in addition to ‘debt-labelled’ accounts, can include accrual accounts like unearned revenue.

Debt to Equity Ratio = Total liabilities / Stockholders’ equity (Total Equity)
Example: $5,500,000 / $3,725,000 = 1.48 or 148%

Profitability Ratios

Profit margin is calculated with selling price (or revenue) taken as base times 100. It is the percentage of selling price that becomes profit, whereas, "profit percentage" or "markup" is the percentage of cost price that one gets as profit on top of cost price. When selling something one should know what profit percentage one will get on a particular investment, so companies calculate profit percentage to find the ratio of profit to cost.

Net Profit Margin = Net profit / Total Revenue
Example: $1,092,000 / $4,805,000 = .227 or 22.7% (of every dollar in the form of earnings)

The profit margin is useful mostly for internal comparison. It is difficult to compare with accuracy the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss, or a negative margin. Profit margin is an indicator of both a company's pricing strategies and how well it controls costs. Differences in competitive strategy and product mix cause the profit margin to vary among different companies. Examples follow:

1. If an investor makes $10 in revenue and it costs, $1 to earn it, when he or she take costs away he or she has a 90% margin. A 900% profit on a $1 investment.
2. If an investor makes $10 in revenue and it costs, $5 to earn it, when he or she take costs away he or she has a 50% margin. A 100% profit on a $5 investment.
3. If an investor makes $10 in revenue and it costs $9 to earn it, when you take the cost away, the investor is left with 10% margin, an 11.11% profit on a $9 investment.
4. On the other hand, profit percentage calculates as follows: Suppose that you buy something for $50.00 and then sell it for $100.00.

Cost price = $50
Selling price (revenue) = $100
Profit = $100 − $50 = $50
Profit percentage (profit divided by cost) = $50/$50 = 100%
Return on investment multiple = $50 / $50 (profit divided by cost)

If the revenue is the same as the cost, profit percentage is 0%. The result above or below 100% can be calculated as the percentage of return on investment. In this example, the return on investment is a multiple of 0.5 of the investment, resulting in a 50% gain.

Return on Investment (ROI) is the benefit to an investor resulting from an investment of some resource. A high ROI means the investment gains compare favorably to investment cost. As a performance measure, ROI is useful to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. In purely economic terms, it is one way of considering profits in relation to ‘capital’ invested.

ROI (return on investments) (assets) = Total Revenue (Net income) / Total assets
Example: $1,092,000 / $9,225,000 = .118 or 11.8%

Purpose

In business, the purpose of the "return on investment" (ROI) metric is to measure, per period, rates of return on money invested in an economic entity in order to decide whether, or not, to undertake an investment. It is also useful as an indicator to compare different project investments within a project portfolio. The project with best ROI assumes priority.