Analyzing Company Performance with Ratio Analysis

The information contained in financial statements and notes can be used to provide insight into the financial strength and weakness of a company. To take the financial information to the next step it becomes necessary to examine the relationship between accounts.

The nature of the analysis depends on what information the reader is looking for. For example a short-term note holder would be primary concerned with the company’s ability to pay its current obligations and therefore place a lot of weight on the company’s current ratio. The holder of long–term debt might look at projected earnings and cash flow.

Management will be concerned with all of the factors. This financial information can be useful for the decision-making purposes on a daily basis. It can also be compared with other companies in the same industries to determine where you are in the industry. Management can graph the results to identify company trends.

The following financial ratios are those most often used to analyze a business.

Return on Equity:

Measures the return on the investment made by the owner. This number will appear in a percentage and can be compared to other returns the owners might have if invested in some other medium. This ratio shows the percentage return the owner is making on money invested. When evaluating a "good" return rate, one should take into account the level of business risk assumed. (6.2% earnings may be acceptable in a bank account but not in a risky business environment!)

Return on Assets:

Measure return on the gross investment in the business, includes that financed by the owner as well as that financed by creditors. The relationship between the return on assets and on equity is indicative of the effect of the business financial leverage. If the leverage is positive, the return on equity will be greater than the return on assets.

RATIOS TO MEASURE SAFETY AND LIQUIDITY

Net Working Capital:

Indicates the ability to meet short-term obligations, reporting the excess of current assets over current liabilities. If this number is positive the company should have funds to pay short-term obligations.

Current ratio:

This also indicates the ability to pay current liabilities as they mature, providing the ratio is greater than 1:1 or greater. A ratio of 1:1 indicates a more positive is the net working capital.

Debt to equity ratio:

This indicates the balance between total equity ownership (common and preferred stockholders) and amount due to creditors. The greater the number, the more leveraged is the company.

Times Interest Earned:

This measures the ability of a company to cover the payments of interest to creditors.

Debt service ratio:

This ratio is an indicator of the company’s ability to pay both interest and the current principal installments on its outstanding debt and suggests the degree of safety for creditors concerning currently due debt service obligations.

Receivable turnover ratio / Collection Period:

This ratio measures the efficiency of the company’s receivable collection efforts. If the company also makes sales for cash, "Total sales on account" should be substituted for "total sales".

Inventory turnover ratio / Days in Inventory:

A measure of how quickly inventory is sold in a year. The greater the turnover ratio, the less cost arising from holding inventory.