Financial Ratios. Their Meaning and Usage.

By |2021-07-09T02:17:12-05:00May 16th, 2020|Comments Off on Financial Ratios. Their Meaning and Usage.

Financial Ratio Analysis

Written by James R. Leichter

Purpose of Financial Ratios

The purpose of financial ratios is to gauge the overall financial health of an organization. They may provide warning signs of potential threats to a company’s solvency, gauge how efficiently an organization applies or utilizes assets, or even how well an organization collects their accounts receivable.

Introduction

There are basically three types of financial ratios. They include solvency, profitability, and efficiency. Solvency ratios gauge how easily an organization can pay its bills. Profitability ratios judge how good a particular organization is at generating a profit. Efficiency ratios analyze such things as how well a company is able to utilize its working capital or other assets, as well as how quickly the company collects on their accounts receivable. Depending on your company’s own individual needs, you may also wish to develop certain other ratios that are not strictly financially related. These types of ratios may typically be classified as sales ratios, marketing ratios, and even investment ratios.

Financial managers should make a careful study of all financial reports, each and every month. These financial reports must include, in addition to an income statement and profit and loss statement, all relevant financial ratios to your particular industry, personal requirements, or your company’s unique needs.

We have briefly described each ratio below. We have attempted to cover its usage and meaning adequately. We have also attempted to give you an acceptable range to consider when evaluating or benchmarking your own organization’s financial ratio data. These ranges should be considered only as rough guidelines for you to follow. Your company may have different needs than the industry as a whole.

Important Warnings

  1. Financial ratios are only as accurate as your least accurate financial numbers. These ratios may mean nothing if your company does not practice good quality bookkeeping that is timely and substantially accurate.
  2. You must practice accrual type accounting for these ratios to be meaningful.
  3. As part of accrual accounting, your company must enter bills and other liabilities as your company encounters them. You must enter (record) revenue as your company encounters it.
  4. See your accountant if you have any concerns regarding accrual accounting or the validity of these ratios.

Solvency Ratios

Current Ratio

Formula: (Current Assets / Current Liabilities) x 100.

A solvency ratio, the current ratio expresses the working capital relationship of current assets to cover current liabilities. A rule of thumb is that at least 2 to 1 is considered a sign of sound financial strength. However, much depends on the standards of the specific industry you are reviewing. If a company’s inventory is slow in selling, a stronger current ratio is required. Quick Ratio is a related and more preferred ratio.

Approximate Industry Average: 1.5 to 2.1

Our Recommendation: 2.0 or greater.

Quick Ratio *

Formula: (Current Assets – Inventory) / Current Liabilities

This is a key ratio. The quick ratio is a solvency ratio and is sometimes called the “acid test” or “liquid” ratio. It measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash. Only cash and accounts receivable would be included, as inventory and other current assets would require time and effort to convert into cash.

Approximate Industry Average: 1.2 to 1.6

Our Recommendation: 1.35 or greater.

Doomsday Ratio (Cash to Current Liabilities) *

Formula: Cash / Current Liabilities.

The ratio gets its name because it measures the companies able to handle the absolute worst-case scenario; liabilities must be satisfied immediately. This is the most demanding of all solvency ratios. It indicates how easily the company can pay off its liabilities in a very fast manner. Conservative financial managers prefer this solvency ratio over the Current Ratio and Quick Ratio because it deals only with the cash portion of current assets. We generally recommend a ratio of 1. In other words, you have $1.00 in cash to pay off $1.00 of liabilities.

Approximate Industry Average: 0.45 (estimated)

Our Recommendation: 1.00

Total Liabilities to Total Assets

Formula: (Total Liabilities / Total Assets) x 100.

This ratio compares assets to liabilities. It measures the company’s ability to absorb asset reductions arising from operating loses without jeopardizing its ability to satisfy creditors and other financial obligations.

Approximate Industry Average: 1.15

Our Recommendation: 1.25 or greater.

Debt to Equity (Current Liabilities to Net Worth)

Formula: (Current Liabilities / Net Worth) x 100.

Indicates the amount due to creditors within a year as a percentage of the owners or stockholder’s investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80 percent.

Approximate Industry Average: .78 to 1.6

Our Recommendation: 0.75 or less.

Working Capital to Total Assets

Formula: (Total Assets / Working Capital) x 100.

This ratio indicates what percent of assets are in the form of working capital. This ratio is important because if liabilities must be paid quickly, only working capital may be converted to cash relatively quickly.

Approximate Industry Average: .10 to .12

Our Recommendation: .25 or greater.

Cash to Working Capital

Formula: (Cash / Working Capital) x 100.

This ratio indicates what percent of working capital is in the form of cash. This ratio is important because if liabilities must be paid quickly, only cash may be used immediately. Company’s need to avoid having a significant portion of their working capital be in the form of something other than cash.

Approximate Industry Average: 0.2 (estimated)

Our Recommendation: .35 or greater.

Retained Earnings to Total Assets

Formula: (Retained Earnings / Total Assets) x 100.

This ratio indicates how much of the company’s assets are in the form of retained earnings. A number may suggest that retained earnings are too high. A low number can suggest that owners are removing too much of the company’s assets from the company.

Approximate Industry Average: 0.15 (estimated)

Our Recommendation: .25 or greater.

Owner’s Equity to Total Liabilities

Formula: (Total Liabilities + Net Worth) x 100.

This ratio shows how all the company’s debt relates to the equity of the owners or stockholders. The higher this ratio, the less protection there is for the creditors of the business.

Approximate Industry Average: 100 (estimated)

Our Recommendation: 140 or greater.

Efficiency Ratios

Gross Profit Dollars per Person Day *

Formula: Gross Profit / Available Person Days

Indicates how well you are applying available field labor top producing gross profit dollars (as opposed to merely sales). This is the number of full business days available to perform work per billable person. It is important because you only have so many days to generate sales to overcome fixed costs (overhead). The calculate Available Person Days, multiply the total number of billable technicians by the total number of available days they can work. Subtract weekends, holidays, vacation, sick days, etc. Most companies have 240 person-days per employee per year.

Approximate Industry Average: Varies Widely by Segment

Our Recommendation: $600 and Higher (depending on department)

Sales to Total Assets

Formula: (Net Sales / Total Assets) x 100

An efficiency ratio, assets to sales ratio measures the percentage of investment in assets that is required to generate the current annual sales level. If the percentage is abnormally high, it indicates that a business is not being aggressive enough in its sales efforts, or that its assets are not being fully utilized. A low ratio may indicate a business is selling more than can be safely covered by its assets.

Approximate Industry Average: 40 (estimated)

Our Recommendation: 60 or greater.

Accounts Payable to Sales

Formula: Accounts Payable / Net Sales x 100

The accounts payable to sales ratio is an efficiency ratio and measures how the company pays its suppliers in relation to the sales volume being transacted. A low percentage would indicate a healthy ratio.

Approximate Industry Average: 12 (estimated)

Our Recommendation: 10 or less.

Fixed Assets to Net Worth

Formula: (Fixed Assets + Net Worth) x 100

This ratio shows the percentage of assets centered on fixed assets compared to total equity. Generally, the higher this percentage is over 75 percent; the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery, and the margin for operating funds becomes too narrow for day to day operations.

Approximate Industry Average: 65 (estimated)

Our Recommendation: 50 or less.

Inventory Turnover (AKA: Sales to Inventory)

Formula: Annual Net Sales / Inventory

This ratio provides a yardstick for comparing stock-to-sales ratios of a business with others in the same industry. When this ratio is high, it may indicate a situation where sales are being lost because a concern is under-stocked and/or customers are buying elsewhere. If the ratio is too low, this may show that inventories are obsolete or stagnant.

Approximate Industry Average: 5 (estimated)

Our Recommendation: 7 or greater.

Average Age of Inventory

Formula: (Inventory / COGS) / 365

This ratio indicates how old your inventory is on average expressed in days. A high number may indicate your inventory is obsolete or not being sold fast enough. A low number may mean you are not carrying enough inventory and money is being wasted acquiring it.

Approximate Industry Average: Varies Widely by Segment

Our Recommendation: 60 or less.

Accounts Receivable Collection Period

Formula: Days in Period / (Income / Accounts Receivable)

The collection period ratio is an efficiency ratio and is helpful in analyzing the “collectability” of accounts receivable, or how fast a business can increase its cash supply. Although businesses establish credit terms, their customers for one reason or another do not always observe them. In analyzing a business, you must know the credit terms it offers before determining the quality of its receivables. While each industry has its own average collection period (number of days it takes to collect payments from customers), there are observers who feel that more than 10 to 15 days over terms should be of concern.

Approximate Industry Average: Varies Widely by Segment

Our Recommendation: 40 or less.

Accounts Payable Period

Formula: Days in Period / (Income / Accounts Payable)

This ratio indicates how long it takes your company to pay its bills in days. The higher the number the better; as long as you are paying your bills on time and taking discounts (if available).If the number is low (under 30 days for example), you may be paying your bills too quickly. This ratio only has significance if you enter bills.

Approximate Industry Average: Varies Widely by Segment

Our Recommendation: 30 or greater.

Sales to Net Working Capital

Formula: Sales / Net Working Capital

Also called “Working Capital Turnover”. The sales to net working capital ratio is an efficiency ratio and measures the number of times working capital turns over annually in relation to net sales. A high turnover rate can indicate over-trading (an excessive sales volume in relation to the investment in the business). This ratio should be reviewed in conjunction with the assets to sales ratio. A high turnover rate might also indicate that the business relies extensively upon credit granted by suppliers or the bank as a substitute for an adequate margin of operating funds. Note: Working capital is Current Assets reduced by Current Liabilities.

Approximate Industry Average: 3.75 (estimated)

Our Recommendation: 5.0 or greater.

Sales to Total Labor

Formula: (Labor COGS + Labor Expenses) / Sales)) x 100

Efficiency Ratio: Indicates how much of your total sales revenue (AKA: Income) is consumed by all payroll and labor-related expenses. The lower the number the better because it suggests that you are efficiently using employees to create sales and manage them.

Approximate Industry Average: Approximately 35%

Our Recommendation: 30% or less.

Sales to Administration Labor

Formula: (Labor Expenses / Sales) x 100

Efficiency Ratio: Indicates how much of your total sales revenue (AKA: Income) is consumed by payroll and labor expenses related to the office (usually administration and office workers). The lower the number the better, because it suggests that you are efficiently using your administrative employees to manage or process your sales.

Approximate Industry Average: Approximately 13%

Our Recommendation: 10% or less.

Sales to Field Labor

Formula: (Labor COGS / Sales) x 100

Efficiency Ratio: Indicates how much of your total sales revenue (AKA: Income) is consumed by payroll and labor expenses related to the field (usually sales, technicians, and installers). The lower the number the better, because it suggests that you are efficiently using your employees to create sales. This ratio should be calculated by department.

Approximate Industry Average: Approximately 32%

Our Recommendation: 22% or less.

Field Labor Sales to Field Labor Cost *

Formula: (Labor COGS / Labor Sales) x 100

Efficiency Ratio: Indicates how much of your total labor sales revenue is consumed by payroll and labor expenses related to labor sales. The lower the number the better, because it suggests that you are efficiently using your employees to create labor sales. This ratio should be calculated by department.

Tip: This is the same as looking at your gross profit margin on labor sales.

Approximate Industry Average: Approximately 36%

Our Recommendation: 23% or less.

Profitability Ratios

Return on Sales (Net Profit Margin) *

Formula: (Net Profit Before Taxes / Net Sales) x 100.

Return on sales (net profit margin) ratio is a profitability ratio. It measures the profits before taxes on the year’s sales. The higher this ratio, the better prepared the business is to handle downtrends brought on by adverse conditions. It is considered a key ratio if nothing else, due to its ubiquity. It can be overrated.

Approximate Industry Average: 2.4%

Our Recommendation: 10 or greater.

Return on Net Worth (Return on Equity) *

Formula: (Net Profit Before Taxes / Net Worth) x 100

Also called Return on Investment. This is a key ratio and is considered a profitability ratio. Return on net worth ratio measures the ability of a company’s management to realize an adequate return on the capital invested by the owners in the company. If you are an investor, this can be more important to you than Return on Sales.

Approximate Industry Average: 62% to 145% (depends on revenue and size)

Our Recommendation: 25% or greater.

Return on Assets (Net Profit to Total Assets)

Formula: (Net Profit Before Taxes / Total Assets) x 100. A profitability ratio, the return on assets ratio is the key indicator of the profitability of a company. It matches net profits after taxes with the assets used to earn such profits. A high percentage rate will tell you the company is well run and has a healthy return on assets.

Approximate Industry Average: 6% to 7%

Our Recommendation: 15% or greater.

Breakeven Sales Factor

Formula: 100 x ((Income – COGS) / Expense)

This ratio reveals how much of a sales reduction your company can absorb before it starts losing money. Assuming that gross margin factors and other expenses remain constant, this ratio indicates how far down the company’s sales must go to reach breakeven. Many companies have such small net profit margins that the absolutely cannot absorb much of a sales decrease before they are losing significant dollars. A ratio of 110 indicates that the company’s sales are 10% over breakeven. In other words, the company can absorb only a 10% reduction in sales to reach breakeven. A score of 90 indicates the company is currently losing money with sales that are only 90% of what they should be.

Approximate Industry Average: 97% to 98%

Our Recommendation: 110 or greater.

Z-Score Bankruptcy Model

Introduction

This famous and widely used model (or ratio) represents the important work of New York University’s Professor Edward I. Altman. Originally, Altman studied 33 public corporations that filed for bankruptcy and 33 control firms selected at random. Using a very sophisticated statistical technique referred to as multiple discriminate analyses (MDA), he discovered that bankruptcy could be predicted up to two full years in advance through ratio analysis.

Small-Business managers using this formula should keep in mind that Altman excluded corporations with assets less than one million dollars. Also, decision making based on the Z-Score factors is biased towards short term credit risk avoidance and may not be appropriate for companies needing to develop new products, services, or markets. Please note different industries may operate under conditions that make the Z-Score factor (the actual score) less clear. Depending on the industry, some organizations can operate effectively with low Z-Score factors that may otherwise cause problems for other industry groups. Managers need to consider this when evaluating their Z-Score performance.

Does the Altman Z-Score Work?

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event. In subsequent tests over 31 years up until 1999, the model was found to be 80-90% accurate in predicting bankruptcy one year prior to the event.

Model Limitations

Financial managers need to realize that there are important limitations to this financial model. As you will learn, net profit before taxes (NPBT) is one of the most important of all factors. If management or officers do not pay themselves annual compensation that is considered “typical” or “normal”, net profit may be over or understated. This will adversely affect your Z-Score analysis, as it does not consider NPBT. Full-time working business owners should be paid approximately 6% to 8% of sales or whatever they could reasonably earn working at a similar job doing similar work.

If management does not track inventory properly or does not perform bookkeeping functions properly and accurately, the Z-Score may be completely useless.

Management is cautioned of these limitations and strongly encouraged to carefully study the formula and consider what other factors may be improperly stated and therefore affect the Z-Score.

The Original Formula

Z = (0.717* X1) + (0.847* X2) + (3.107* X3) + (0.42* X4) + (0.998* X5)

Where

X1 = Working Capital / Total Assets. This measures liquid assets as a firm in trouble will usually experience shrinking liquidity.

X2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the firm, as shrinking profitability is a warning sign.

X3 = Earnings Before Interest and Taxes / Total Assets. This ratio shows how productive a company in generating earnings, relative to its size.

X4 = Market Value of Equity / Book Value of Total Liabilities. This offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent (i.e. its liabilities exceed its assets).

X4A = Net Worth / Total Liabilities. The purpose of this ratio is the same as X4 but is used when the market value of equity is not known. Most small privately held companies would not have access to an accurate number, so this is used as a conservative replacement.

X5 = Sales / Total Assets. Asset turnover is a measure of how effectively the firm uses its assets to generate sales.

Z = Overall Index. Compare this number to the Bankruptcy Probability Chart below.

Bankruptcy Probability Chart

The original Z-Score classifications are:

> 2.90 suggests good financial health.

1.23 to 2.90 is a gray area where bankruptcy cannot be predicted accurately.

< 1.23 suggests bankruptcy.

Newer Altman Z2 Bankruptcy Model

This is what is used in Total Office Manager.

The usefulness of the original Z score measure was limited by two of the ratios. The first ratio X4, is Market Value of Equity divided by Total Liabilities. If a firm is not publicly traded, the market value of its equity is difficult to determine. The other ratio is X5, or Sales divided by Total Assets (Asset Turnover). The original Z Score expects a value that is common to manufacturing. This ratio varies significantly by industry and is not a key ratio to the residential light commercial contracting industry.

To deal with this, there is a more general revised Z-score for non-manufacturing businesses called Z2. This ratio modifies X4 and removes X5. These changes make the ratio far more relative to the typical HVAC, Plumbing, and Electrical contractor that has a good mix of income categories.

The Z2 Formula is:

Z2 = (6.56*X1) + (3.26*X2) + (6.72*X3) + (1.05*X4A)

You will notice this formula places no value on the market value of equity (what the value of the company is on the open market). It shifts the emphasis to solvency and liquidity. To gain a high score, a company needs to have more cash and less debt.

Bankruptcy Probability Chart

The new Z2 Score classifications are:

> 2.99 suggests good financial health.

1.81 to 2.99 is a gray area where bankruptcy cannot be predicted accurately.

< 1.81 suggests bankruptcy.

Bankruptcy Probability Chart – Extended Version

We have expanded the chart to provide a wider range of information.

Z-Score > 4.50

A Z-Score >= 5.0 suggests that the company is in excellent financial condition and possibly over-capitalized. This company should have more than adequate cash, and other current assets, to meet its current obligations over the next twelve months. Bankruptcy or insolvency during the next two years is highly unlikely unless conditions worsen rapidly and significantly. An analysis of efficiency and profitability ratios, such as Return on Assets, should be made to verify that the company is not overfunded. It may be possible that the company is not utilizing its current assets in the most efficient way.

Z-Score = 4.01 to 4.50

A Z-Score >= 4.50 suggests that the company is in very good financial condition and well-capitalized. This company should have sufficient cash, and other current assets, to meet its current obligations over the next twelve to twenty-four months. Bankruptcy or insolvency for the next two years is unlikely unless conditions worsen rapidly and significantly.

Z-Score = 3.51 to 4.00

A Z-Score >= 4.00 suggests that the company is in good financial condition. This company should have sufficient cash, and other current assets, to meet its current obligations over the next twelve months. Bankruptcy or insolvency during the next two years is unlikely unless conditions worsen rapidly and significantly.

Z-Score = 3.00 to 3.50

A Z-Score >= 3.50 suggests that the company is in moderately good financial condition. Bankruptcy or insolvency during the next two years is not particularly likely unless conditions worsen rapidly and significantly. Careful and regular attention should be paid to this company’s financial matters and immediate action taken if financial indicators worsen.

Z-Score = 1.81 to 2.99

A Z-Score of 1.81 to 2.99 falls within the “ignorance zone” of the Z-Score model and the data is inconclusive. However, it may suggest that the company’s financial condition is not strong and may be unstable. Bankruptcy or insolvency during the next two years cannot be accurately predicted.

Further analysis is required. A careful study of all financial reports, data, and ratios should be made by qualified personnel and, if required, corrective action be taken immediately.

Z-Score = 1.7 to 1.80

CORRECTIVE ACTION REQUIRED. A Z-Score >= 1.7 suggests that the company’s financial condition is weak, and its future is in danger. The company is severely undercapitalized and needs additional current assets. Bankruptcy or insolvency during the next two years is very possible if corrective action is not taken immediately. Qualified personnel should make a careful study of relevant financial reports, data, and ratios.

Z-Score < = 1.69

INSOLVENCY WARNING: A Z-Score < 1.6 suggests that the company’s financial condition is very weak, and its future is in grave danger. The company is severely undercapitalized and needs additional current assets. Bankruptcy or insolvency during the next two years is highly likely if corrective action is not taken immediately. Qualified personnel should make a careful study of relevant financial reports, data, and ratios. A “turn-around” plan should be produced and implemented as soon as possible.

Sources

http://www.exceluser.com/reports/zscore-bankruptcy-prediction.htm

https://en.wikipedia.org/wiki/Altman_Z-score

Corporate Bankruptcy in America, Edward I. Altman, John Wiley and Sons, Inc.

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