How does a business investor compare a small railroad line serving only a few states to a large railroad like Union Pacific?

Answer: Ratios!

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).

Business ratios are strictly a function of the financial reports audited by Certified Public Accountants. 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:

1) Liquidity Ratios

2) Activity Ratios

3) Leverage Ratios

4) Performance Ratios

5) Valuation Ratios

The respective ratios within each category have their own article under the **‘How to Read the Financial Statements‘** section of **Accounting**.

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.

Contents

**Sectors and Industries**

Sectors reflect a broad list of many industries working towards the same goal. However the underlying industries are distinctly different. Here are some examples:

__Sector__ __Industries__

** Transportation** Trucking, Railroads, Shipping (FedEx, UPS etc.), Ocean Going Vessels, Cabs, Airlines

** Utilities ** Water, Electric, Natural Gas, Sewage Treatment, Communications

** Raw Materials** Mining, Chemicals, Lumber, Synthetics, Aluminum

** Food ** Farming, Livestock, Fishing, Processing, Baking, Restaurants, Fast Food

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.

**DO NOT USE RATIOS TO COMPARE COMPANIES IN DIFFERENT INDUSTRIES OR WORSE DIFFERENT SECTORS.**

Now that reader understands when to use ratios it is now time to explain the different categories and their corresponding ratios.

**Liquidity Ratios**

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).

There are two different groups of accounts on the balance sheet used in evaluating liquidity ratios. The first group is **current assets.**

Current assets comprise several accounts and of course the most coveted asset – cash. Here is a short list of the most common current assets:

* Cash

* Marketable Securities

* Accounts Receivable

* Inventory

* Short-Term Notes Receivable

* Prepaid Expenses

On the flip side of this is the second group used in evaluating liquidity **– current liabilities**.

Examples of current liabilities include:

* Accounts Payable

* Credit Card Payables

* Accrued Payroll

* Accrued Taxes

* Lines of Credit

* Current Portion of Long-Term Debt

These two groups are the basis of all four liquidity ratios.

**Current Ratio**

This ratio is straight forward, it is simply:

Current Ratio = __Current Assets__

. Current Liabilities

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). So 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.

The drawback to this ratio is the ease of manipulation explained in more detail in the current ratio article. So to reduce risk more sophisticated business investors use **Quick Ratio**.

**Quick Ratio**

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. The idea behind the quick ratio is to pay those liabilities in the very near future. So here is the formula:

Quick Ratio = Cash + Current Receivables + Marketable Securities (Discounted)

. Accounts Payable + Accrued Expenses

This ratio is more refined than the all-encompassing current ratio.

Just like the current ratio the value is stated as a number to ‘1’. In general this ratio is superior via reduced risk in comparison to current ratio.

**Cash Ratio**

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.

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.

Since cash is of the utmost importance in business, the ability to generate cash is a sign of good liquidity too.

**Operating Cash Flow**

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:

Operating Cash Flow Ratio = __Cash Flow from Operations__

. Current Liabilities

To help you understand more about liquidity ratios I encourage you to read the following articles on this site:

* **Cash Flows – Introduction**

* **Working Capital**

* **Working Capital Cycle**

**Activity Ratios**

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:

* **How to Read a Simple Balance Sheet**

* **Fixed Assets Section of the Balance Sheet**

* **Long-Term Debt**

* Equity Section of the Balance Sheet

With activity ratios, the higher the number the more effective the business performs in utilizing its assets as it produces (earns) income. So let’s take a look at the first one.

**Inventory Turnover**

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:

Inventory Turnover Ratio (Rate) = __Cost of Good Sold for the Period__

. Average Value of Inventory *Note ‘A’

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.

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.

**Reivables Turnover**

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.

Here is the formula:

**Receivables Turnover Ratio** (Rate) = __ Adjusted Sales on Account__ * Note ‘B’

. Average Accounts Receivable Balance

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.

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.

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.

**Working Capital Turnover**

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:

Working Capital Turnover Ratio = __Adjusted Sales
__ Average Working Capital *Note ‘C’

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. Do not give this ratio a lot of weight in your decision model.

**Fixed Asset Turnover**

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:

**Fixed Asset Turnover Ratio** (Rate) = __Adjusted Sales Related to Property, Plant and Equipment
__ Average Fixed Costs *Note ‘D’

Note ‘D’ – Average fixed costs are restricted to the original purchase price paid and not the depreciated value.

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).

**Total Asset Turnover**

One of the principles of business is** leverage**. 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.

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). So here is the formula:

Total Asset Turnover Ratio = __ Adjusted Sales__

. Average Total Assets *Note ‘E’

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.

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. So pay attention to these non performing assets.

**Payables Turnover**

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:

**Payables Turnover Ratio** = __Adjusted Sales__

. Average Accounts Payable

Just like other averages, use as many interim financial report periods as possible to approximate the true payables average for a year.

**Leverage Ratios**

As stated above, leverage reflects the ability to use debt and/or equity to increase profits. So these ratios focus on long-term debt and equity issues in the balance sheet. The first is a simple percentage ratio.

**Debt Ratios**

This simple formula reflects the portion of all assets financed with debt. Debt in this case includes short and long-term liabilities. Therefore the total debt ratio equals:

__Total Liabilities__

Total Assets

It is comprised of two subset ratios:

Current Debt Ratio = __Current Liabilities__,

. Total Assets AND

Long-Term Debt Ratio = __Long-Term Debt__

. Total Assets

In small business, once the total debt ratio exceeds 75% it means the equity position to total assets is less than 25%. **Equity Ratio** is:

__Equity__

Total Assets

If Equity is less than 25% the company is ‘Thinly Capitalized’ and there is an increased chance of **insolvency.**

**Interest Coverage**

With debt comes interest to service that debt. The ability to pay interest is critical as this reflects profitability overall. Some industries such as apartment complex housing is highly dependent on debt. Therefore interest is a significant factor or percentage of the operational profit; often referred to as earnings before interest, taxes, depreciation and amortization (EBITDA).

For those readers not familiar with EBITDA I encourage you to read the following series:

**EBITDA**

**EBITDA – Buyer Beware**

**EBITDA – Drawbacks**

The **Interest Coverage Ratio** = __EBITDA__

. Interest Expense

Naturally the higher the ratio the more likely the long-term debt ratio (percentage) is lower. When evaluating interest coverage take into consideration the long-term debt ratio.

**Debt to Equity**

The debt to equity ratio is a variation of the equity ratio (Total Equity/Total Assets). This particular ratio measures the volume of total debt dollars borrowed in comparison to equity (capital contributed and lifetime earnings retained) in the business. The formula is:

**Debt to Equity Ratio** = __Total Liabilities__

. Total Equity

This ratio identifies the risk to creditors. Unlike many ratios, the lower the value the lower the risk to creditors. For small business any value greater than 2.0 is undesirable. Once this value hits 3.0 or higher; the eyeballs of the owners should pop out. Banks prefer to loan money when the ratio is lower than a 1.0. Again each industry is different and those with high cost long-term assets are given more leeway with this ratio (Real Estate Sector, Raw Materials Sector).

**Performance Ratios**

Before continuing with this section the reader must be aware of the various profit (sometimes called ‘Margin’) points in the income statement. Please read: **Gross, Operational and Net Profit.**

Performance ratios shift the basic relationship from the balance sheet to the income statement. In these ratios the results are customarily reported as a percentage. Most of them as a percentage of net sales. There is a difference between gross sales and net sales. Net sales is determined after considering discounts, returns and allowances.

The single most used ratio in business is **gross profit margin**.

**Gross Profit Margin**

This single ratio is the number one discussed ratio in business conversation. Even many sophisticated businessmen fail to use it properly because they are not aware that gross profit margins are different in every industry.

Why?

Answer: It relates to the inherent costs against the sales.

Basically the gross profit margin is the percentage of net sales after deducting costs. The interesting part is that cost of sales is different in every industry. Take for example this summary of gross profit for a restaurant:

. **SAL’s ITALIAN GOURMET**

. Income Statement

. For the Year Ending December 31, 2015

Gross Sales $843,602

Adjustments __(19,207) __

Net Sales 824,395

Cost of Meals Served:

. Prime Costs $397,481

. Alcohol 191,337

. Supplies __26,912__

. Sub-Total Cost of Meals Served __615,730
__Gross Margin $208,665

Sal’s gross profit margin is almost 26%. Is this good or bad? The answer is ‘it depends’. The gross profit margin is used to compare other similar restaurants or Sal’s history over several years. If the gross profit margin has steadily increased (even 1 to 2% a year) for several years, this is a very positive sign.

**THE GROSS PROFIT MARGIN IS DIFFERENT WITH EACH INDUSTRY. USE THE GROSS PROFIT MARGIN TO COMPARE THE BUSINESS OVER TIME OR AGAINST VERY SIMILAR BUSINESSES.**

** **

**Operating Profit Margin**

Operating profit margin is the amount earned after deducting general and administrative expenses from gross margins. These expenses include:

* Management – **front and back office** payroll

* Facilities – rent, utilities, maintenance

* Office – technology, supplies, communications

* Insurance

* Taxes and Licenses – revenue taxes, property taxes and other local taxes, includes any licenses required by governmental authorities

* Other – professional fees, transportation, miscellaneous

The operating profit margin is commonly referred to as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Just like gross profit margin, the resulting profit is divided by net sales.

**Net Profit Margin**

This ratio takes the profit aspect one step further and is net of capital costs (interest, depreciation, amortization), one time costs (insurance gains/losses, sale of fixed assets, lawsuits) and income taxes. It is the amount that is left over for investor **dividends**.

Again, just like the other two profit points, it is divided by net sales.

**Return on Equity**

In addition to evaluating net profit against sales, investors evaluate net income against equity. A common mistake with the ratio is referring to this as **return on investment** (ROI). Return on investment is a project driven value and not really a comprehensive value as return on equity is formulated to provide.

**Return on Equity** = __Net Profit
__ Total Shareholder’s Equity at the Beginning of the Year *Note ‘F’

Note ‘F’ – The equity section of the balance sheet includes the current net profit, so exclude the current earnings to net the original balance of equity at the beginning of the year.

**Return on Assets**

Very similar to how return on equity is calculated, the return on assets is the net income divided by the total assets. There is a problem with this formula. The assets include the value of net income. So the correct technical formula is:

**Return on Assets** = __Net Profit__

. Total Assets minus Net Profit

Here the percentage result evaluates the overall performance of the assets to generate income. If assets were less, the ratio would increase and this a sign of better management.

Now it is time to look at ratios for overall value.

**Valuation Ratios**

Valuation ratios are a derivative of share price. Share price is typically set in the open market. For small business the share is usually set by the existing owner. So valuation ratios in small business should be take with a grain of salt, actually the whole salt shaker. But it is good for the investor to understand the valuation ratio even if they are not applicable to small business.

**Price to Earnings (P/E)**

This ratio is the most widely accepted ratio to value stock. Basically the formula is used to determine if the share price is high or low (or acceptable) compared to the earnings of the company. The formula is:

**Price to Earnings Ratio** = __Current Share Price__

. Earnings Per Share

There are several issues related to this formula, too much to cover for introduction purposes. For now, understand that as the P/E Ratio goes higher (mid level is around 14 to 16) the price per share is getting more expensive against the performance of the company. Large publically traded companies rarely see P/E ratios greater than 25.

**Price to Sales**

This tool is more appropriate for small business than the P/E ratio. With this ratio the investor is analyzing the ability of the company to generate revenue against the equity investment. The formula is:

**Price to Sales Ratio** = __Current Share Price__

. Revenue per Share

To illustrate this ratio, let’s look at an example.

An owner of a small plumbing company with 20 employees is considering bringing in a newly licensed employee as a partner. The company generates $4 Million a year in sales. There are currently 5 owners in the company, each with 2,000 shares for a total of 10,000 shares. They estimate each share is worth $100 and will allow an apprentice to join for $120 per share. What is the ratio?

Price to Sales Ratio = __$120 Sale Price per Share__

. $4,000,000 of Sales/10,000 Shares (5 * 2,000/ea)

Price to Sales Ratio = __$120__

. $400

Price to Sales Ratio = .3

Here the lower the value the more attractive the investment. Imagine if the sales were $600 per share? The ratio would be a .2.

**Price to Cash Flow**

This last valuation tool is similar to the price to sales ratio explained above. With price to cash flow the investor must look at the cash flows statement for total cash earned from operations. The formula is:

Price to Cash Flow Ratio = Current Share Price

. Operating Cash Flow Per Share

With this ratio the lower the outcome the better the value for the share price. As an example using the prior example in price to sales ratio of the plumbing business, suppose the plumbing company generates $40 per share in cash flow. The ratio is:

Price to Cash Flow = __$120
__. $40

Price to Cash Flow is 3.0.

This is a bit high, not extreme but high. Ideally any value less than 1.0 is a good opportunity. A 1.0 means the investor will earn his share price back in less than one year.

**Summary**

An investor should **NEVER** value a business based on one or two ratios. Any valuation using less than eight ratios is risky. A smart investor will utilize at least a dozen ratios to get an inclination of value. There are five categories of financial ratios:

* Liquidity

* Activity

* Leverage

* Performance

* Valuation

Each category has at least two ratios. Altogether there are more than 20 to evaluate financial status compared to any company of any size. So long as they are in a similar industry. **Act on Knowledge**.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on **‘My Services‘** in the footer of this article.

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