Ratio Analysis

Sometimes individual numbers or figures, such as sales or profit, are not enough to truly paint a picture of what is going on. Ratio analysis offers an opportunity for a more thorough analysis by comparing trends and relationships between different aspects of the financial statements. The following are only a very select few of the ratios commonly used in financial analysis.

Gross Margin Ratio

(Revenue less cost of goods sold)/Revenue

Gross margin ratio is used to determine the margin earned as a percentage of revenues. It represents the total income earned after deducting the costs of creating those revenues. The higher the percentage, the more profit the business retains on each dollar of revenue earned.

Current ratio

Current assets / Current liabilities

Current ratio is used to compare the total current assets to total current liabilities. The ratio is often used to show the business’s ability to repay current liabilities using current assets. The higher the percentage, the more able the business is to repay current liabilities.

Inventory Turn-over

Cost of goods sold / Average inventory

Inventory turn-over is used to determine the number of times per year that inventory is sold and replaced. The higher the inventory turn-over the lower the risk of inventory obsolescence, however inventory turn-over should be compared to industry or historical averages.

Return on Equity (ROE)

Net Income / Shareholders’ Equity

Return on Equity is used to determine the total return or income earned on the equity contributed by a shareholder. The higher the return on equity the more profitable the business is for its shareholders.

Return on Assets (ROA)

Net Income / Assets

Return on Assets is used to determine the total return or income earned on the assets owned by a business. The higher the return on assets the better managed the assets are to produce profit. The measure is often used to determine the profitability of the assets regardless of the financing methods.

Receivable Turnover

Sales / Average accounts receivable

Receivable turn-over is used to determine the number of times per year that sales are collected. A lower receivable turn-over may indicate a risk of uncollectible sales, however should be compared to industry or historical averages.

Average Collecting Period

365 days / Receivable Turnover

The average collecting period (an extension of the receivable turnover) represents the average number of days it takes for the business to collect. Again a higher average collecting period may indicate a risk of uncollectible sales.