Financial Ratios

Financial Ratios

– Liquidity – current ratio (current assets ÷ current liabilities)

Liquidity: the extent to which a business can meet its financial commitments in the short-term (a period of less than 12 months).

Accounts receivable: the money the business is owed by its debtors (For example: customers buy off you now and pay later). The business needs to ensure there are enough current assets to sell quickly to pay its creditors accounts payable (where you buy now and pay later).

Current ratio: this is one way to measure liquidity. It measures the level of current assets available to meet a business’s current liabilities. It shows the ability of business to meet its short-term debts.

  • Current ratio = current assets ÷ current liabilities

– gearing – debt to equity ratio (total liabilities ÷ total equity)

Solvency: the ability of a business to meet its financial commitments, in the long term. This ratio indicates the relationship between the long-term funds provided by creditors, and those provided by the business owners.

It is an indication of stability. Solvency ratios measure the degree of financial risk in that if a company cannot meet its debts as the fall there is a risk of insolvency.

This ratio is usually expressed as a percentage.

  • Gearing ratio = total liabilities ÷ owner’s equity

– profitability – gross profit ratio (gross profit ÷ sales); net profit ratio (net profit ÷ sales); return on equity ratio (net profit ÷ total equity)

Gross Profit Ratio

The relationship between profit and sales helps determine how each dollar of sales generates profit. It is measured using percentages.

  • Gross profit ratio = (gross profit ÷ sales) x 100

Net Profit Ratio

The net profit ratio measures the operating costs or expenses of a business. It is measured in percentages and means that each dollar is generating a new profit of $X dollars.

  • Net profit ratio = (net profit ÷ sales) x 100

Return on Owner’s Equity

This ratio indicates how much the owner’s investment in the business is earning. The return to owners is higher if most of the assets are financed with borrowings. This is because debt is tax-deductable and is generally cheaper than equity finance. It is higher risk option because interest must be paid even when things go wrong.

  • Return on owner’s equity = (net profit ÷ owner’s equity) x 100

– efficiency – expense ratio (total expenses ÷ sales), accounts receivable turnover ratio (sales ÷ accounts receivable)

Efficiency Ratio

  • Efficiency: the ability of the firm to use its resources effectively in ensuring financial stability and profitability.
  • A business improves its efficiency when it increases thee outputs from a given amount of inputs.

Expenses ratio = (total expenses ÷ sales) x 100

Accounts Receivable Turnover Ratio

  • Accounts receivable: the money debtors owe you.
  • How many days on average it takes to collect accounts receivables
  • It evaluates how effective the business is at collecting credit.

Accounts receivable turnover ratio = Sales ÷ accounts receivable

– comparative ratio analysis – over different time periods, against standards, with similar businesses

There are 4 main ways businesses use these ratios:

  1. To make comparisons over different time periods
  2. To make comparisons with similar businesses/industries
    • Determine if businesses performance is above average
    • If results are below the industry standard, then the business plan will need to be reviewed and new strategies implemented
    • Australian Tax Office has established a set of industry benchmarks from its analysis of businesses tax returns. This is used as a guide and can assist managers in interpreting business performance.
  3. To measure against common standards
  4. To consider relationships with general economic conditions

General standards for ratios

  1. Liquidity – current assets should be 1.2 and 2.5 times greater than current liabilities
  2. Return on equity – this result should be greater than the current interest rate
  3. Gearing debt to equity ratio – result should be no higher than 60%

Extract from Business Studies Stage 6 Syllabus. © 2010 Board of Studies NSW.