Financial Statement Ratio Analysis

Business Credit Management UK

Financial Statement Ratio Analysis

When you are analysing a financial statement, it is best to reduce amount comparisons to percentages or ratios so that you have an easy way to judge those comparisons. And if you compare those ratio results with what you know to be good, fair or bad, you have a way of determining the health of a business.

Simply put, ratio analysis is changing amount comparisons to ratios and then comparing those ratios to a known standard.

Ratios to Determine Strength & Weaknesses

Everyone in the business of analysing financial statements has a few favourite ratios they utilise when determining the strengths or weaknesses of a specific financial statement. The ratios that are used could change depending upon the industry the business is in, the size of the business, the accounting method that is used by the business and the amount of the credit desired and how healthy the company is.

If you are dealing with a high risk business, you will probably want to use more ratios than if you were dealing with a healthy, low risk business.

Common Ratios

The following are a list of common ratios and their definitions:

Ratio Name	Formula
Current Ratio	Current Assets / Current Liabilities - Indicates the ability of a company to pay its short term creditors from its resources of current assets therefore indicating fixed assets will remain intact
Liquidity Ratio or Acid Test	Current Assets minus Stock / Current Liabilities - Indicates the ability of a company to pay its debts as they fall due. This ratio is generally considered to be a more accurate assessment of a company's health than the current ratio as it reduces the risk of relying on a ratio which may include slow moving or redundant stock. A ratio of less than 0.7 to 1 could mean danger, but in some industries the norm is 0.3 to 1.
Asset Turnover	Turnover / Net Assets - Shows how fully the company is using its capital and how many pounds of turnover is generated by each pound of investment.
Collection Period	Debtors x 365 / Turnover - Measures the length of time a company takes to pay its debts therefore assessing the effectiveness of the company's credit control department.
Creditor Days	Creditors x 365 days / Turnover - Measures the length of time a company takes to pay its creditors.
Working Capital	Current Assets - Current Liabilities.
Gearing	Long term Liabilities + Overdrafts x 100 / Shareholders Funds - Shows the ratio between company's permanent capital Shareholders' funds and reserves) and the total value of loans made to it. The higher the gearing the greater the proportion of borrowed money to "own" money. A highly geared company will have greater vulnerability if there is a sudden fall in profits as interest has to be paid regardless and also if there is a sharp rise in interest rates.
Credit Gearing	Credit Limit x 100 / Shareholders Funds.
Capital Employed/Employees	Total Assets - Total Liabilities / Employees.
Current Debt	Current Liabilities / Shareholders Funds.
Insolvency Ratio	Shareholders Funds / Loss.
Long Term Debt	Long term Liabilities / Total Assets - Current Liabilities. - Shows what proportion of permanent capital has been provided by long term debt.
Profit Margin	Profit before Tax x 100 / Turnover - Measures the margin of profitability on sales throughout the trading year and will vary from industry to industry. The percentage should be relatively constant and any changes investigated. Reasons for changes could be reduced selling price or increase in the cost of sales.
Profit/Employees	Profit / Employees - All employee ratios show the productivity of the company's employees and can be of value if yearly fluctuations are examined within the same industry type.
Profit/Capital Employed	Profit before Tax x 100 / Total Assets - Indicates whether or not a company is generating adequate profits in relation to the resources invested in it.
Return on Shareholders Funds	Profit before Tax x 100 / Shareholders Funds - Indicates whether or not a company is generating adequate profits in relation to the resources invested in it.
Shareholder Liquidity	Shareholders Funds / Long Term Liabilities - Shows how many pounds worth of Shareholders' Funds exist for every pounds worth of long term debt.
Solvency Ratio percent	Shareholders Funds x 100 / Total Assets - Indicates a possible over dependency on outside sources for long term financial support.
Stock Financing	Stock and Work in Progress / Current Assets - Current Liabilities - Compares stock and work in progress to working capital and therefore shows how sensitive working capital is to a fall in stock values.
Stock/Turnover	Turnover / Stock - Measures the number of times stock is converted into sales during the year. It must be borne in mind that different industries would have a different rate of stock turnover.