Business ratios are a set of 22 different analytical formulas used to evaluate the overall value an performance of a business. In general, a sophisticated entrepreneur will utilize no less than a dozen of the business ratios to gain an overall understanding of the financial status of a company.
In yesterday’s post, I indicated that if Union Pacific’s share price drops to $156.79 that the fund would use its excess cash to purchase shares. Well, today at 10:35 AM it did drop to $156.39.
This is purely a historical record of the investment fund for railroad stocks based on the value investing concept developing using business ratios.
Another performance ratio used in business is return on equity. It is similar to return on assets except return on equity uses one section of the bottom half of the balance sheet.
Far and above the most valuable liquidity ratio is the operating cash ratio. Unlike the other liquidity ratios that are balance sheet derived, the operating cash ratio is more closely connected to activity (income statement based) ratios than the balance sheet.
Operating profit margin refers to the value earned as a percentage of net sales. The operating profit is often referred to as earnings before interest, taxes, depreciation and amortization, (EBITDA). This is a misleading reference as operating profit is actually defined differently by industry sector. EBITDA is used primarily in valuing businesses.
Within the group of activity ratios, the total assets turnover rate is the broadest in scope. Similar to other activity ratios, it utilizes net sales as the numerator. However the denominator doesn’t focus in on a single balance sheet asset group like the working capital turnover or fixed assets turnover rates, it includes all assets.
Every business buys on account whether it is a traditional vendor account like that found in retail or simply using a credit card. A third party provides credit which creates debt for the business. The debt ratio reflects the percentage of assets covered by debt.
The fixed assets turnover rate is another activity ratio whereby an income statement financial characteristic is compared to a balance sheet asset section. In this case, comparing adjusted sales against historical cost of fixed assets. This financial business ratio is only effective for business operations that are fixed asset intensive. So with service based industries like carpet cleaning, professional firms and medical practices this particular ratio is impractical.
One of the liquidity ratios used in business is the cash ratio. It is a much more effective tool for small business than the traditional current or quick ratio. Although the cash ratio is more difficult to manipulate in small business, most entrepreneurs miscalculate the result
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).
