- Calculate and interpret operating ratios.
Operating Ratios
Operating ratios measure how effectively a company is utilizing its resources. These ratios also help identify areas for improvement in operations that will improve overall financial health. Operating ratios are commonly used when comparing a business to “industry standards” or benchmarks.
- Average-Inventory-Turnover Ratio. This ratio measures the number of times that a company’s inventory turns over or sells out during the accounting period. It is very common for retail businesses to rely heavily on this ratio for obvious reasons – their primary source of revenue is derived from selling inventory. This ratio can also help a business determine if its inventory is obsolete, understocked or overstocked and is calculated as follows:
Average Inventory Turnover Ratio= (Cost of Goods Sold)/(Average Inventory)
Average inventory is determined by inventory at the beginning of the accounting period to inventory at the end of the accounting period and dividing by 2. This ratio will vary considerably by business type. For example, an automobile dealership may turn its inventory only twice a year as opposed to a grocery store that may turn its inventory 15 times annually. Because of this disparity it is key to compare a business’s inventory turn-over ration to similar businesses or industry standards.
- Average-Collection-Period Ratio. This ratio is often referred to as days sales outstanding because it tells the business the average number of days that it takes to collect its accounts receivable. In order to calculate this ratio a business must first calculate its receivables turnover ratio as follows:
Average Collection Period Ratio= (Days in the Accounting Period)/(Receivables Turnover Ratio)
The higher the receivables turnover ratio, the shorter the time between a credit sale and payment. Once we have this ratio we can then calculate the Average-Collection-Period ratio as follows:
One of the most beneficial uses for this ratio is comparison to industry averages. This ratio, like the Average-Inventory-Turnover Ratio varies among industries. A company can also use this ratio to evaluate its credit terms. A rule of thumb is that the collection period ratio should be no more than one-third greater than its credit terms. For example, if a company extends credit to its customers and gives them 30 days to pay their bill then their average collection ratio should be no more than 40 days (30 + 30 × 1/3).
- Average-Payable-Period Ratio. This ratio measures the number of days it takes a company to pay its accounts payable. Like the collection period ratio, we must first calculate the Payables Turnover Ratio as follows:
Payables Turnover Ratio= Purchases/(Accounts Payable)
Then we are able to calculate the Average-Payable-Period Ratio as follows:
Average Payable Period Ratio= (Days in Accounting Period)/(Payables Turnover Ratio)
One of the most meaningful comparisons for this ratio is to compare the ratio to the terms offered by suppliers and creditors. If the average payable period ratio is higher than the terms offered by creditors, then this may signal that the company needs to improve its accounts payable system. A high average payable period ratio may also be discovered by companies that are short on cash. Allowing this ratio to remain high has the long-term consequences of damaging the company’s reputation with suppliers and creditors and may make it very difficult for the company to purchase necessary materials or inventory on credit terms. On the other hand, if the average payable period ratio is very low then the company may not be putting its cash to its best use by paying creditor too fast. Cleary there is a “happy medium” when it comes to managing payables for a business.
- Net-Sales-to-Total Assets Ratio. This ratio measures a company’s ability to generate sales revenue based upon the assets of the business. It is a measure of productivity but is only meaningful when compared to similar businesses or industry benchmarks. The Net-Sales-to-Total Assets Ratio is calculated as follows:
Net Sales to Total Assets= (Net Sales)/(Net Total Assets)
For the purposes of calculating this ratio, total net assets is the sum of everything the business owns (cash, buildings, equipment, land, tools, etc.) less depreciation.
Profitability Ratios
Profitability ratios are a measurement of how efficiently a company is being managed and run. More than any other type of ratio, profitability ratios provide owners and managers with information about a business’s ability to use its resources to generate a profit.
- Net-Profit-on-Sales Ratio. This ratio measures a company’s profit per dollar of sales. The ratio is expressed as a percentage and shows the percentage of each dollar remaining after paying expenses. The ratio is calculated as follows:
Net Profit on Sales = Net Profit/Net Sales
For a small, privately owned company this ratio generally ranges from 3 to 7%, but like many of the other ratios we have discussed it varies based on the industry. Retail businesses generally have a net profit on sales ratio between 2 and 4% but other industries such as the healthcare industry have ratios as high as 15%. When businesses see their net profit on sales ratio fall, they often undertake drastic cost-cutting measures. This is not always the best approach as many times cost reduction measures have a negative impact on the overall health and future of the business. Rather, businesses should look at their gross margin in comparison to similar businesses or their industry. If their gross sales are comparable, then it makes sense for the business to investigate what in their operations is driving less revenue to the bottom line (net profit).
- Net-Profit-to-Assets Ratio. This ratio is also referred to as a return-on-assets ratio because it measures how much profit a company is generating for every dollar it has invested in the assets of the company. This ratio is calculated as follows:
Net Profit to Assets Ratio= (Net Profit)/(Total Assets)
This ratio provides information about how “asset intensive” a business or industry is. Manufacturing companies that require expensive machinery to produce a product will have a much lower net profit to asset ratio than an accounting firm, for instance. Again, this is a comparative ratio. A business will look at the industry average for similar businesses to determine if changes need to be made in how assets are utilized in the course of day-to-day operations.
- Net-Profit-to-Equity Ratio. This ratio is often referred to as a return on net worth ratio because it measures the owner’s return on investment (ROI). It reflects the percentage of the owner’s investment in the business that is returned annually via the profit of the business. It is one of the most important ratios when evaluating the company’s overall profitability. This ratio is computed as follows:
Net Profit to Equity Ratio= (Net Profit)/(Owners Equity)
One of the most common uses for this ratio is in comparison to a company’s cost of capital (interest rate on money borrowed). The business should produce a rate of return (ROI) that exceeds its cost of capital.
In general, ratios are useful in measuring a firm’s overall performance and identifying areas where the firm can improve. In addition to being able to calculate these ratios, owners and managers must understand how to interpret them in order to increase efficiency and profitability. Ratio analysis is an ongoing process, comparing the ratios not only to industry benchmarks but also to the company’s own ratios from prior periods.
