How does a business investor compare a small railroad line serving only a few states to a large railroad like Union Pacific?<\/span><\/p>\n Answer: Ratios!<\/span><\/p>\n Ratios are used in business to compare companies of different sizes within the same industry. The goal is to discover the best investment for return on your stock purchase. Business ratios essentially equalize different size companies within the same industry. A common mistake is to compare two different industries within the same sector (explained below).<\/span><\/p>\n Business ratios are strictly a function of the financial reports audited by Certified Public Accountants<\/span><\/strong><\/a>. There are five categories of financial ratios. Each category has no less than two different ratios. The sections below explain the five categories listed here:<\/span><\/p>\n 1) Liquidity Ratios<\/span> A common mistake made by business investors is using ratios to compare different industries or sectors of the economy. To start gaining an understanding of the value of the proper approach to ratio analysis; the reader must understand the difference between sectors and industries.<\/span><\/p>\n Sectors reflect a broad list of many industries working towards the same goal. However the underlying industries are distinctly different. Here are some examples:<\/span><\/p>\n Sector<\/u>\u00a0<\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0Industries<\/u><\/strong>\u00a0<\/span> The ratios accepted as outstanding in one industry are not applicable to a different industry even one within the same sector. Utilizing ratios for comparisons is restricted to comparing companies within the same industry.<\/span><\/p>\n DO NOT USE RATIOS TO COMPARE COMPANIES IN DIFFERENT INDUSTRIES OR WORSE DIFFERENT SECTORS.<\/strong><\/span><\/p>\n Now that reader understands when to use ratios it is now time to explain the different categories and their corresponding ratios.<\/span><\/p>\n Liquidity ratios are designed to evaluate the ability of a company to pay their obligations over a short period of time. Typically a short period of time is defined as either one accounting cycle (a year) or one reporting period (a quarter or in small business – one month).<\/span><\/p>\n There are two different groups of accounts on the balance sheet used in evaluating liquidity ratios. The first group is current assets<\/span><\/a>.<\/strong><\/span><\/p>\n Current assets comprise several accounts and of course the most coveted asset – cash. Here is a short list of the most common current assets:<\/span><\/p>\n * Cash<\/span> On the flip side of this is the second group used in evaluating liquidity – current liabilities<\/span><\/a><\/strong>.<\/span><\/p>\n Examples of current liabilities include:<\/span><\/p>\n * Accounts Payable<\/span> These two groups are the basis of all four liquidity ratios.<\/span><\/p>\n Current Ratio = Current Assets<\/u><\/span> It is the most encompassing of the liquidity ratios and is often cited in business discussions. It is commonly stated as a number value compared to ‘1’ (One). The ‘1’ is of course the entire current liabilities balance (value). Thus, if current assets is $32,000 and current liabilities is $10,000 the ratio is stated as ‘3.2 to 1’. The higher the value the better the financial liquidity to address paying current liabilities.<\/span><\/p>\n The drawback to this ratio is the ease of manipulation explained in more detail in the current ratio article. To reduce risk, more sophisticated business investors use Quick Ratio<\/strong>.<\/span><\/a><\/span><\/p>\n The quick ratio eliminates those current assets that have true liquidity issues involved. A good example is inventory. Often inventory takes more time than other assets to turn into cash. Other examples include accounts receivable that have a revolving nature to them or extended periods of time to pay.\u00a0 The idea behind the quick ratio is to pay those liabilities in the very near future.\u00a0 So here is the formula:<\/span><\/span><\/p>\n Quick Ratio = Cash + Current Receivables + Marketable Securities (Discounted)<\/span><\/span> This ratio is more refined than the all-encompassing current ratio.<\/span><\/p>\n Just like the current ratio the value is stated as a number to ‘1’.\u00a0 In general this ratio is superior via reduced risk in comparison to current ratio.<\/span><\/p>\n Just like the quick ratio, the cash ratio is very highly defined in its nature. Here only cash and the discounted value of marketable securities is included in the numerator. The denominator includes all those current liabilities due during the next thirty days and includes accounts payable, accrued expenses, credit card balances and any principle due for maturing notes.<\/span><\/p>\n This ratio will be less than the quick ratio due to the exclusion of accounts receivable. However if you have a cash ratio greater than 3:1, it is a good sign of a liquid position.<\/span><\/p>\n Since cash is of the utmost importance in business, the ability to generate cash is a sign of good liquidity too.<\/span><\/p>\n Operating cash flow ratio reflects the ability of ongoing operations to cover (pay) the short-term obligations. The final value is typically lower than the other liquidity ratios. This isn’t a poor value it is just normal. Ideally any operating cash flow ratio of more than 1:1 means that current liabilities can be paid from cash earnings within one accounting cycle. The formula is:<\/span><\/p>\n Operating Cash Flow Ratio = Cash Flow from Operations<\/u><\/span> To help you understand more about liquidity ratios I encourage you to read the following articles on this site:<\/span><\/p>\n * Cash Flows – Introduction<\/strong><\/span><\/a>\u00a0<\/span> This set of ratios are strictly restricted to the balance sheet and its relationship to the income statement. To fully understand the six ratios explained, please reacquaint yourself with the balance sheet and the respective major groups of accounts:<\/span><\/p>\n * How to Read a Simple Balance Sheet<\/strong><\/span><\/a><\/span> With activity ratios, the higher the number the more effective the business performs in utilizing its assets as it produces (earns) income. Let’s take a look at the first one.<\/span><\/p>\n One of management’s goals in controlling the financial resources is to be effective in keeping inventory value low. If a business is capable of minimizing inventory value and still meet customer demand without delays than money is available for other needs. The tool used to evaluate this activity level is inventory turnover. The formula is below:<\/span><\/p>\n Inventory Turnover Ratio (Rate) = Cost of Good Sold for the Period<\/u><\/span> Note ‘A’ – To calculate average value of inventory obtain the value of the ending inventory balance for all twelve months. Add them up and divide by twelve.<\/span><\/p>\n The higher the ratio or turns the better as it indicates the ability to order and receive the inventory as needed. Some industries will naturally face barriers such as political (if inventory supply is resourced from out of the country), shipping or contractual disagreements in minimizing inventory value. Simply stated; sometimes a business has to purchase supply to last an entire year. Think of brewers of beer; hops have a limited growing season so brewers purchase inventory for a year at a time.<\/span><\/p>\n In a working capital cycle the final step is payment from customers refilling the cash coffers of the business. To evaluate collection activity the receivables are divided into total sales to determine how frequently the receivables are paid.<\/span><\/p>\n Here is the formula:<\/span><\/p>\n Receivables Turnover Ratio (Rate) =\u00a0 Adjusted Sales on Account<\/u>\u00a0 * Note ‘B’<\/span> Note ‘B’ – The ratio may use sales in lieu of adjusted sales on account; however it is more accurate to use adjusted sales on account. Remember many businesses have a mix of customers; those that pay at the counter and those that charge to their account. The formula is more accurate if you restrict the sales to only those on account charges.<\/span><\/p>\n Ideally a 12:1 ratio is inherently perfect as this indicates the ability to collect all twelve months of sales within 30 days. A lower value indicates accounts receivable is growing or aging. A higher value indicates an aggressive collection process reducing accounts receivable.<\/span><\/p>\n If you use only sales in this formula an analyst couldn’t truly ascertain the effectiveness without knowing the proportion of sales on account. Cash sales will distort the result.<\/span><\/p>\n Working capital’s technical definition is all current assets less current liabilities. In effect it is excess current assets. It is the amount of money available to take advantage of a situation or endure a sudden hardship or emergency. Look at this formula:<\/span><\/p>\n Working Capital Turnover Ratio = Adjusted Sales Note ‘C’ – This particular ratio is generally unreliable because of the working capital cycle involved. For those industries with extended cycles the ratio goes higher because the average working capital value is lower.\u00a0 Do not give this ratio a lot of weight in your decision model.<\/span><\/p>\n For those industries with a high reliance on property, plant and equipment, this ratio is used to evaluate how efficient production is related to the fixed assets cost. The formula is as follows:<\/span><\/p>\n Fixed Asset Turnover Ratio<\/strong> (Rate) = Adjusted Sales Related to Property, Plant and Equipment Note ‘D’ – Average fixed costs are restricted to the original purchase price paid and not the depreciated value.<\/span><\/p>\n As with most activity ratios the higher the number the more efficient the relationship between the two values. The primary purpose of this ratio is to evaluate the investment into property, plant and equipment. Are the fixed assets getting maximum utility (activity).<\/span><\/p>\n One of the principles of business is leverage.\u00a0 Leverage is a term customarily used with debt and equity to maximize profit. The greater a business can extend debt (the lever) and still increase profit (raise the weight) using assets (the fulcrum) the better.<\/span><\/p>\n In physics, as the fulcrum gets bigger, using the proper length of the lever can lift the weight higher. Well the total asset turnover ratio evaluates this fulcrum. Basically, a business wants the smallest fulcrum possible to lift the greatest amount of weight (measured with sales). Here is the formula:<\/span><\/p>\n Total Asset Turnover Ratio =\u00a0 Adjusted Sales<\/u><\/span> Note ‘E’ – Average assets is calculated using the maximum number of interim financial statements as possible; ideally 12 for small business. Add up all twelve monthly ending balances and divide this total by 12 to obtain the average total assets.<\/span><\/p>\n There are several drawbacks to this ratio. Often the fulcrum is bigger on purpose. Many young growing operations invest significant dollars into future plans such as purchasing land for future expansion or have large dollar values for research and development. This investment increases the total average assets and reduces the ratio. Pay attention to these non performing assets.<\/span><\/p>\n This ratio reflects the frequency over the course of a year that the payables amount is paid. Remember payables are customarily used to purchase materials, services and general expenses. If you think about it, an investor wants this ratio to be greater than twelve which means the business is paying their bills in less than 30 days. Here is the formula:<\/span><\/p>\n
\n 2) Activity Ratios<\/span>
\n 3) Leverage Ratios<\/span>
\n 4) Performance Ratios<\/span>
\n 5) Valuation Ratios<\/span><\/p>\nBusiness Ratios – Sectors and Industries<\/span><\/strong><\/h2>\n
\n Transportation<\/strong> \u00a0 \u00a0 \u00a0Trucking, Railroads, Shipping (FedEx, UPS etc.), Ocean Going Vessels, Cabs, Airlines<\/span>
\n Utilities \u00a0<\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Water, Electric, Natural Gas, Sewage Treatment, Communications<\/span>
\n Raw Materials<\/strong> \u00a0 \u00a0 \u00a0 Mining, Chemicals, Lumber, Synthetics, Aluminum<\/span>
\n Food \u00a0<\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Farming, Livestock, Fishing, Processing, Baking, Restaurants, Fast Food<\/span><\/p>\n![\"\"](\"https:\/\/businessecon.org\/wp-content\/uploads\/Key-Point.jpg\")
<\/a>Business Ratios – Liquidity Ratios<\/span><\/strong><\/h2>\n
\n * Marketable Securities<\/span>
\n * Accounts Receivable<\/span>
\n * Inventory<\/span>
\n * Short-Term Notes Receivable<\/span>
\n * Prepaid Expenses<\/span><\/p>\n
\n * Credit Card Payables<\/span>
\n * Accrued Payroll<\/span>
\n * Accrued Taxes<\/span>
\n * Lines of Credit<\/span>
\n * Current Portion of Long-Term Debt<\/span><\/p>\nCurrent Ratio<\/span><\/strong><\/h3>\n
\n<\/a>This ratio is straight forward, it is simply:<\/span><\/p>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Current Liabilities<\/span><\/p>\nQuick Ratio<\/span><\/strong><\/h3>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Accounts Payable + Accrued Expenses<\/span><\/p>\nCash Ratio<\/span><\/strong><\/h3>\n
Operating Cash Flow<\/span><\/strong><\/h3>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Current Liabilities<\/span><\/p>\n
\n * Working Capital<\/strong><\/span><\/a><\/span>
\n * Working Capital Cycle<\/strong>\u00a0<\/span><\/a><\/span><\/p>\nBusiness Ratios – Activity Ratios<\/span><\/strong><\/h2>\n
\n * Fixed Assets Section of the Balance Sheet<\/strong><\/span><\/a><\/span>
\n * Long-Term Debt<\/strong><\/span><\/a><\/span>
\n * Equity Section of the Balance Sheet<\/span><\/a><\/strong><\/span><\/p>\nInventory Turnover<\/span><\/strong><\/h3>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Average Value of Inventory *Note ‘A’<\/span><\/p>\nReceivables Turnover<\/span><\/strong><\/h3>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Average Accounts Receivable Balance<\/span><\/p>\nWorking Capital Turnover<\/span><\/strong><\/h3>\n
\n<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Average Working Capital\u00a0 *Note ‘C’<\/span><\/p>\nFixed Asset Turnover<\/span><\/strong><\/h3>\n
\n<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Average Fixed Costs\u00a0 *Note ‘D’<\/span><\/p>\nTotal Asset Turnover<\/span><\/strong><\/h3>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Average Total Assets\u00a0 *Note ‘E’<\/span><\/p>\nAccounts Payable Turnover<\/span><\/strong><\/h3>\n