Using ratios and horizontal and vertical comparisons to look at your financial statements can help you better manage your business. Here are some helpful ways to get more out of your financial statements.
One common way of looking at financial statements is to use a technique called vertical analysis. This is when you take a report like your Profit & Loss and compare different totals on the report to one another. For example, you may look at what percent of income some of your expense line items represent. For example, profitable retailers often see their rent expense sitting at about 3% of their net sales. When compared to Net Sales, Cost of Goods Sold may rest around 50%, and Labor costs around 10-20%, not including owner/executive salaries. If you see something seems to be a much higher or lower percentage that you would expect or want, this might be an area you look into further. Was there an error, or are there issues that you should address in the way you are running your business?
Horizonal Analysis is when you look at a report and compare different periods to another. You might compare current year to prior years, compare to a budget, or look at month-to-month statements. You can see and analyze variations and make educated decisions based on the differences you see. Is income increasing or falling in ways you hoped or expected? If not, why? Are expenses moving in a way you would expect and want? If not, why not? What different decisions should you make because of these movements?
Accounts Receivable (A/R) Turnover and Number of Days of Receivables – Net credit sales ÷ average gross accounts receivable = A/R Turnover. This ratio shows how many times during the year accounts receivable was collected in full. This can tell you whether receivables are excessive when compared to existing levels of credit sales. To find the number of days it takes to turn your receivables, divide 365 by the A/R Turnover rate.
Inventory turnover and Days’ Sales in Inventory – Cost of goods sold ÷ average inventory = Inventory Turnover. This ratio indicates how many times the inventory was sold during the period. You can divide the number of days in the period by the ratio and you know how long it takes you to sell your inventory. (Days’ Sales in Inventory). This is handy, for example, for determining how much inventory you would have to have in stock to reach a certain sales level per period, assuming turnover doesn’t change.
Working capital turnover – Net sales ÷ average working capital (current assets less current liabilities). This ratio measures the effectiveness of using working capital to generate sales.
Fixed Asset Turnover or Total Asset Turnover – Net sales ÷ average fixed assets (or total assets). Helpful to large manufacturing concerns, or other business that require large assets to do business, this ratio measures how efficiently the entity is using capital investment. The ratio reflects the level of sales generated by investments in fixed assets (or total assets). Unfortunately, as an entity’s assets depreciate, the ratio increases. To overcome this problem, some people use gross fixed assets (i.e., before depreciation) for the ratio.
Current Ratio – Current assets÷ current liabilities. This represents the dollars of current assets available for each dollar of current liabilities. The ratio is limited by the fact that current assets may be tied up in inventory or other items that are may not be quickly converted into cash (e.g., prepaid expenses).
Current ratio – (Cash and cash equivalents + marketable securities) ÷ current liabilities. This liquidity ratio is the most conservative measure, as it includes only actual cash and marketable securities to measure cash resources to cover current liabilities.
Current Cash Debt Coverage Ratio – Net cash provided by operating activities ÷ average current liabilities. This ratio measures your ability to pay off your short-term debt with net cash provided by operations.
Quick Ratio or Acid-Test Ratio – (Cash + net receivables + marketable securities) ÷ current liabilities. This represents the assets that are readily convertible to cash (i.e., quickly liquidated assets), available for each dollar of current liabilities.
Working Capital to Total Assets Ratio – Working capital ÷ total assets. Working Capital is current assets minus current liabilities. This ratio shows what percent of your total assets could be liquidated into cash within the year.
Leverage and Profitability Ratios
Leverage Ratios include ratios of Debt to Equity, Debt to Total Assets, Book Value per Share of Stock, Times Interest Earned (Income before taxes and interest divided by interest charges, showing how productive debt is to the business), Cash Debt Coverage Ratios (Net cash provided by operating activities divided by average total liabilities, showing solvency issues), and Cash Flow per Share.
Profitability Ratios include the Rate of Return on Assets, Profit Margin on Sales (Net Income/Gross Sales), Earnings per Share (EPS = Net Income less Preferred Stock Dividends divided by average Stockholders Equity), Price-Earnings Ratio (Market Price of Common Stock divided by EPS), Rate of Return on Owners Equity, and Dividend Payout Ratio (Cash dividends on common stock divided by net income).