Financial Ratios Formulae

This is a quick guide to financial ratios for cooperatives and saccos, extracted from Ojijo’sSuccessful Saccos – Managers’ Guide to Acquire, Retain and Grow Membership, Savings and Assets.

Do I have enough working capital? Will I be able to make payroll and the next flock of bills? Is my debt too high? Will I have any difficulty meeting long-term obligations? Am I using my assets wisely? Is my inventory too large, or does it take too long to turn over? How profitable is my business? Financial ratios help me answer these questions.

The massive amount of numbers in a company’s financial statements can be bewildering and intimidating to many investors. However, through financial ratio analysis, I will be able to work with these numbers in an organized fashion. Financial ratios are indicators used to analyze an entity’s financial performance. Financial ratios are used by bankers, creditors, shareholders and accountants to evaluate data presented on an entity’s financial statements. Depending on the results of the evaluations, bankers and creditors may choose to extend or retract financing and potential shareholders may adjust the level of commitment in a company. Financial ratios are important tools that judge the profitability, efficiency, liquidity and solvency of an entity.

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Financial ratios may be used by managers within a firm, by current and potential shareholders/investors (owners) of a firm, and by a firm’s creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%.

There are four main categories of financial ratios:

  • Liquidity,
  • Profitability,
  • Leverage/Solvency, and
  • Activity/Efficiency

Profitability Ratios

Profitability ratios help users of an entity’s financial statements determine the overall effectiveness of management regarding returns generated on sales and investments.

Profitability ratios are designed to evaluate the firm’s ability to generate earnings. Analysis of profit is of vital concern to stockholders since they derive revenue in the form of dividends. Further, increased profits can cause a rise in market price, leading to capital gains. Profits are also important to creditors because profits are one source of funds for debt coverage. Management uses profit as a performance measure.

There are several ratios that may be used to measure profitability and the income statement contains several figures that may be used for profitability analysis.

Return on Member Equity

A measurement of the co-op’s rate of return on member investment. Always given as a percentage. It shows the interest rate net profits yield on member equity.

Formula: Net Savings X 100 / Member Equity

Net Profit Margin (NPM)

Net Profit Margin measures how much out of every of Sales a company actually keeps in earnings, and hence, our measure of profitability. Profit margin, net margin, net profit margin or net profit ratio all refer to a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each of sales. It is also known as Net Profit Margin.

If the company has a high average net profit margin, it is a high margin of safety, hence, a decline in sales, or lower pricing, will not negatively affect our profitability.

Gross profit margin

The average gross profit on each of sales before operating expenses:

It will depend on the industry I am in, so it is important to measure yourself against industry benchmarks. It is an excellent way of assessing the profitability of each product.

Return on Assets (ROA)/Return on Investment (ROI)

This ratio is an indicator of how profitable a company is relative to its total assets. The greater a company’s earnings in proportion to its assets, the more effectively that company is said to be using its assets. ROA/ROI gives an idea as to how efficient management is at using its assets to generate earnings.

An average ratio of above10% is acceptable shows that the company is better at converting its investment into profit, making large profits with little investment.

Return on Equity

Return on Equity measures the efficiency with which stockholder’s investment has been used. In essence, it measures the company profitability by revealing how much profit a company generates with the money shareholders have invested.  Also known as “return on net worth” (RONW).  Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

From the above ratio, the company is efficient at generating profits from every unit of shareholders’ equity (also known as net assets or assets minus liabilities). A high ROE shows that the company uses investment funds to generate earnings growth. A higher average of above 20% means that the company is a lean, mean profit machine.

For example, if I have invested $200,000 and the business is generating a net income of $100,000 a year, my return on owner’s equity is 50 per cent.  It tends to increase over time as the business grows, especially if my personal investment remains the same. It is a useful way to compare what I have earned from my business to what I may have earned from another investment.

Efficiency /Activity /Asset Turnover Ratios

Activity ratios also known as efficiency or turnover ratios are used to measure how efficiently a business uses its assets. Asset turnover ratios consist of the sales figure in the numerator and the balance of an asset in the denominator.

These ratios measure the effectiveness of management’s decision making.

Inventory To Working Capital Ratio

Indicates the desirable inventory level for the working capital employed.

Formula: Inventory / Net Working Capital

Accounts Receivable Turnover

An indicator of how quickly the firm is collecting from its credit sales. This calculation is Average Gross Receivables, divided by the Net Sales, divided by 365. The results from this ratio may cause the firm to rethink its credit terms. Most firms invest a significant amount of capital in accounts receivable, and for this reason they are viewed as crucial corporate resources. Accounts receivable turnover is a measure of how these resources are being managed and is computed as follows:

 

Annual Sales
Accounts Receivable Turnover = ——————-
Accounts Receivable

A fairly high number by most standards would be considered very strong.

 

Inventory Turnover

An important resource that requires considerable management attention is inventory. Particularly useful if you have trading stock. Shows how often my business’ inventory is sold and replaced in a particular period.

This is another powerful ratio. It indicates the liquidity of the inventory. This is calculated by dividing the Cost of Goods Sold by the Average Inventory. Although monthly inventory totals would generate the best average, they are usually unavailable to an outside investor. Often times the beginning and ending inventory totals are the best available numbers.

Control of inventory is important and is commonly assessed with the inventory turnover measure:

  Annual Sales
Inventory Turnover = ————-
  Inventory

 

Generally, the higher the number the better. The less time goods spend in inventory the better the return the company is able to earn from funds tied up in inventory. A large stale inventory can distort the asset position of the company and should be monitored for that reason also.

For example, if you’ve spent $200,000 on stock over the year and you keep an average of $20,000 worth of stock on hand, your inventory turnover is 10 times a year. As a general rule, it is better to have a higher than lower inventory turnover. A low turnover indicates you have a lot of money tied up in stock for long periods, which is not good for cash flow. Too high a figure could indicate that you don’t have enough stock on hand.

 

Accounts Payable Turnover

Cost of Sales

Average Accounts Payable

The higher the turnover, the shorter the period between purchases and payment. A high turnover may indicate unfavorable supplier repayment terms. A low turnover may be a sign of cash flow problems.

 

Operating Expense Ratio

Compares expenses to revenue.

 

Operating Expenses

Total Revenue

A decreasing ratio is considered desirable since it generally indicates increased efficiency.

 

Earnings Per Share

Shows the earnings available to the owners of each share of common stock

Formula is:

Net Income – Dividends

Number Of Shares (Common Stock)

Days Receivable Ratio

Another measure of a business’ liquidity is how long it takes for the company to collect payments from clients, also known as day’s receivable ratio. Figure the day’s receivable of a business by dividing its average gross receivables by its annual net sales divided by 365. For example, a company with annual net sales of $365,000 and average gross receivables of $40,000 would have a day’s receivable ratio of 40 days.

Formula= 365* Average Receivables /Annual Net Income

 

 Liquidity Ratios

Liquidity is a measure of the business’ ability to pay its bills on time. It is the relationship between current assets and current liabilities. Liquidity is a sensitive barometer of month to month operations.

Liquidity ratios help financial statement users evaluate a company’s ability to meet its current obligations. In other words, liquidity ratios evaluate the ability of a company to convert its current assets into cash and pay current obligations. Common liquidity ratios are the current ratio and the quick ratio. The current ratio is calculated by dividing current assets by current liabilities. A general rule of thumb is to have a current ratio of 2. The quick ratio, or acid test, helps determine a company’s ability to pay obligations that are due immediately.

Net Working Capital

The difference between total current assets and total current liabilities. It indicates the extent to which short-term debt is exceeded by short-term assets.

Formula: Current Assets – Current Liabilities

 

Current Ratio/ Liquidity Ratio

 

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. Also known as “liquidity ratio”, “cash asset ratio” and “cash ratio”.  It compares a firm’s current assets to its current liabilities.

If an entity cannot maintain a short-term debt-paying ability, it will not be able to maintain a long-term debt-paying ability, nor will it be able to satisfy its stockholders. It is safe to assume that current liabilities will be paid with cash generated by current assets. A profitable company still may have difficulty paying its short-term debt. Many companies use accrual accounting and are able to report high profits but are unable to meet its current obligations. The liquidity ratios look at aspects of the company’s assets and their relationship to current liabilities.

 

Quick Ratio/ Acid Test Ratio

The quick ratio of a business is a measure of its financial liquidity. It determines how easily a business could convert assets into cash to cover its liabilities. Companies that have a low quick ratio present a higher risk to investors. Figure the quick ratio of a company by deducting the value of its inventory from its current assets and dividing the total by its current liabilities. For example, if a company has $2 million in assets, of which $1 million is tied in its inventory, and $500,000 in liabilities, it has a quick ratio of 2 to 1.

Formula= (Current Assets – Inventories) / Current Liabilities

Solvency/Leverage Ratios

Solvency is the relationship of long term debt to owners’ equity. It is a measure of the proportion of long term capital being provided by the creditors (debt) versus the owners (equity). It indicates who is financing the permanent assets of the company.

Solvency, or leverage, ratios, judge the ability of a company to raise capital and pay its obligations. Solvency ratios, which include debt to worth and working capital, determine whether an entity is able to pay all of its debts. It is important to ensure the entity can maintain operations during difficult financial periods. The debt to net worth ratio calculation is total liabilities divided by net worth. Working capital is calculated by subtracting current liabilities from current assets.

Solvency Ratio

Indicates the amount invested in the business by the creditors with that invested by the members. The lower the ratio, the higher the creditors’ claims on the assets, possibly indicating the cooperative is extending its debt beyond its ability to repay. However, an extremely high ratio may indicate that the cooperative is managing its assets too conservatively.

Long-Term Debt to Working Capital

Indicates creditor contribution to liquid assets.

Formula: Long-Term Debt / Net Working Capital (Current Assets-Current Liabilities)

Long-Term Debt to Capitalization

Indicates the proportion of total capitalization provided by long-term debt.

Formula: Long-Term Debt / Total Capitalization (Total Debt +Total Equity)

Debt to Equity Ratio/Financial Leverage/Gearing/Risk

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. Whereas the optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity; the maximum acceptable debt-to-equity ratio is 1.5-2 and less. The more non-current the assets (as in the capital-intensive industries), the more equity is required to finance these long term investments.

An average reducing D/E Ratio means the company is being financed from its own financial sources rather than by creditors which is a positive trend. Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. Thus, with low debt-to-equity ratios, the company can be able to attract additional lending capital. Further, the low debt-to-equity ratio indicates that the company will be able to generate enough cash to satisfy its debt obligations. It also provides opportunity to exploit financial leverage.

Debt/EBITDA Ratio

This ratio gives the investor the approximate amount of time that would be needed to pay off all debt, ignoring the factors of interest, taxes, depreciation and amortization. Ratios higher than 5 indicate that a company is less likely to be able to handle its debt burden, and thus is less likely to be able to take on the additional debt required to grow the business. At a ratio of below 5, the company is able to pay off its debts.  This high ratio suggests that the company may want take on less debt, unless the cost of capital is greatly reduced.

A high debt/EBITDA ratio suggests that a firm may not be able to service their debt in an appropriate manner and can result in a lowered credit rating. Conversely, a low ratio can suggest that the firm may want take on more debt if needed and it often warrants a relatively high credit rating.

 

Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio (DSCR), also known as “debt coverage ratio,” (DCR) is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity’s (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition or covenant. The average DSCR of above 1 indicating that the company is producing income which is sufficient to pay back its debts. In essence, the company will have cash flow available to meet annual interest and principal payments on debt.

Formula = Net Operating Income/ Total Debt Service (Amortization + Interest On Loans)

Or

A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say .95, would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.

 

Debt Ratio

Debt Ratio is a financial ratio that indicates the percentage of a company’s assets that are provided via debt. It is the ratio of total debt (the sum of current liabilities and long-term liabilities) and total assets (the sum of current assets, fixed assets, and other assets such as ‘goodwill’). 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 be compared with their industry average or other competing firms.

Total liabilities divided by total assets. The debt/asset ratio shows the proportion of a company’s assets which are financed through debt. A debt ratio of greater than 1 indicates that a company has more debt than assets; meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt and most of the company’s assets are financed through equity. Companies with high debt/asset ratios are said to be “highly leveraged,” not highly liquid as stated above. A company with a high debt ratio (highly leveraged) could be in danger if creditors start to demand repayment of debt.

 

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About Ojijo

Ojijo Pascal, a lawyer, author of 49 books, public speaker, consultant, entrepreneur, investor, poet, pianist, speaker of 19 languages, and InuaKijana Fellow, is the Founder & Lead at GoBigHub, a for profit social enterprise with a 10 year target of being in 1,000 African cities, connecting local entrepreneurs to local investors and contributing to 1% of Africa’s GDP. He is passionate about the role of enterprise in fighting Africa’s challenges of poverty, unemployment, and low productivity. He believes that connecting the entrepreneurs to local sources of capital while providing business mentorship and promoting group business and investment ventures through business clubs and investment clubs is the answer to build better lives in Africa. Read Ojijo’s Complete Profile Here.

 

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