And why the quick ratio isn’t valid.
By Ed Mendlowitz
77 Ways to Wow!
Ratios are tools used to evaluate a company’s financial statements.
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Here are some of the more commonly used ratios.
1. Working Capital Ratio
Current assets ÷ current liabilities
Illustration: Current assets of $2,500,000 ÷ current liabilities of $1,250,000 = 2
This is also called the current ratio. Its purpose is to determine how the business can handle its daily operations. A number greater than 1 is good, with the greater the number the better. Less than 1 indicates an “insolvent” company and one that needs to be watched closely. The current assets include assets likely to be converted into cash within the next year, while current liabilities are due to be paid within the next year.
2. Debt to Equity
Total debt ÷ stockholders’ equity or capita
I prefer the long-term debt to equity ratio. See next ratio.
3. Long-Term Debt to Equity
Long-term debt ÷ stockholders’ equity
Illustration: LTD of $9,000,000 ÷ S/H equity of $6,000,000 = 1.5
The purpose is to determine how leveraged the company is. The greater the long-term debt in relation to equity,
- the more leveraged the company is,
- the more sensitive to interest rate increases it is and
- the more sensitive it is to situations that could cause a temporary or permanent inability to make principal payments timely.
Long-term debt holders usually have covenants that place restrictions on the company, causing adherence to certain controls or measures that are triggered when they are violated.
Long-term debt includes all debt except the current liabilities. If perchance the current liabilities exceed the current assets, this will be evident in the working capital ratio.
A similar ratio is total debt to equity, which I do not think is as effective of a measure because the total debt includes current liabilities with no offset for current assets and this makes the ratio harder to use as a tool.
4. Receivables Turnover or Days to Collect
365 ÷ (net sales revenue ÷ average net receivables)
Illustration: 365 ÷ ($12,000,000 ÷ $3,000,000) = 91 days
Note: To determine average net receivables, divide the beginning and ending receivables by 2.
This indicates how many days sales are tied up in receivables, giving an indication about how fast sales are converted into cash. The longer the period, the greater the possibility that cash will be tight, necessitating a slowdown of vendor payments or the need for additional capital or borrowing.
5. Return on Assets
Net profit ÷ average of total assets.
Illustration: $1,000,000 profit ÷ $12,000,000 average total assets = 8.33%
This indicates how well the company is doing utilizing its assets. I think a better ratio is return on equity. The reason I do not use this is that the company could have recently borrowed $5,000,000 and it could be invested in short-term marketable securities until utilized. This would increase its total assets by that $5,000,000, distorting the return on assets percentage.
6. Return on Equity
Net profit ÷ average stockholders’ equity
Illustration: $1,000,000 profit ÷ $2,500,000 S/H equity = 40%
This appears to be a better measure of resource utilization. A further ratio could be return on market value or market cap. This is more appropriate for a public company with a readily ascertainable market value.
If this is applied to a private company using a market cap formula for its valuation it can provide interesting insights. For instance, a private company earning $1,000,000 applying a 15 percent market cap percentage or return on investment percentage can indicate a company value of $6,700,000.
Another way of looking at this is: Where there is an industry standard such as a percentage or multiple of sales is to use that value as the denominator instead of S/H equity.
Still another way would be to adjust S/H by the unstated values of certain assets the company has.
Note: For public company, the return on market cap is 1 ÷ the P/E ratio. For instance, if the P/E is 20 the return on market value is 5 percent. There are other variations on this ratio, especially where there is considerable debt and high interest expenses, but that is not for now where the purpose is to provide basic ratios.
7. Return on Sales or Net Profit Margin
Net profit ÷ net sales
Illustration: $1,000,000 ÷ $12,000,000 = 8.33%
This shows how much ends up on bottom line. A note about using these ratios. When working with public companies they usually work. With private companies additional thought needs to be applied.
For instance, is the net profit before or after income taxes? If the entity is an S corporation, partnership or LLC it would not pay income taxes, but the owners would be paying it personally on their individual tax returns.
Also, the controlling owners could be taking higher than normal compensation or excessive fringe benefits, making comparisons with other companies not feasible. It could also make comparisons between years of the same company inappropriate because these amounts could vary greatly from one year to the next.
8. Earnings Before Interest and Taxes or EBIT
Net profit + interest + taxes added back
This is a method to normalize earnings and make operational comparisons more consistent by adding back interest and taxes. Interest is a function of borrowing, which is usually necessitated by a shortage of capital.
A fully capitalized company would not have to borrow for capital purposes and make interest payments; or, if it did borrow, it would be to level out short-term cash flow needs, or possibly to fund equipment or real estate. Adding back interest eliminates this bias. Of course, some entities do not pay tax, and some could pay significantly different state and local taxes depending upon their location. This is another normalization feature.
9. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
Net profit + interest + taxes + depreciation + amortization
This is a variation on EBIT that I do not use. I feel it’s greatly misused because while it adds back the depreciation and amortization that was deducted to arrive at net income, it takes no account of normal recurring fixed asset additions, which are usual for companies with equipment. This is an example of something that is used that is not understood but where the user feels it makes them a “player” or places them in a “knowledgeable” position. Bull duty!
10. Gross Profit Margin
1 – (Cost of sales ÷ net sales)
Illustration: 1 – ($8,000,000 cost of sales ÷ $12,000,000 sales) = 33.3%
This indicates the percentage of each sale that is left over after subtracting the direct costs of what was sold. The greater the margin the better. Companies with high margins have greater dollars available from sales to be used for overhead and fixed and operating expenses and available profits.
11. Inventory Turnover
Cost of sales ÷ average inventory
Illustration: $8,000,000 ÷ $1,600,000 = 5
This shows that the inventory turns over five times a year.
The greater the number, the better managed the company is. For example, inventory that turns over eight times a year is much better than inventory that turns over three times a year.
The lower the number, the longer inventory is held and the greater the risk of not selling it and of inventory becoming stale, obsolete or damaged.
Some people translate the inventory turnover into inventory in days, which is determined by dividing 365 by the inventory turnover rate. For example, 365 ÷ 5 = 73 days. This means that the company is holding 73 days of sales in its inventory. Be aware that there are always exceptions, such as in some cases a large inventory would create greater customer traffic and sales.
Others
There are myriad others, but these are some of the more popular ratios. Ratios can be categorized into types such as for liquidity, performance and capital structure, but there are not that many shown here, and I did not think it mattered here to categorize them.
The purpose of ratios is to provide a quick look at certain big picture or essential items. All ratios are better used when they can be compared with previous periods to determine trends. The more periods, the better able to detect developing trends. For more serious analysis, I prefer to have as many as five periods for comparison. In many cases it is not as much the ratio that matters, as the change and trend.
What’s Wrong with the Quick Ratio or Acid-Test Ratio?
I purposely left this off my financial statement ratios listing because I do not think it is valid, and here is why.
This ratio is (cash + marketable securities + accounts receivable) ÷ current liabilities. This is a popular ratio, but I don’t think it is too valid and doesn’t provide any better indication than working capital. This is a variation on the working capital ratio in that it only measures immediate debt-paying ability. It does not include inventories and prepaid expenses, which are considered, for this calculation, as less liquid. Well, duh, so is accounts receivable. Every business has embedded as permanent amounts a certain level of accounts receivable, as well as inventory and accounts payable.
I think a better indication of bill-paying ability is its cash and marketable securities divided by the total monthly payments the organization needs to make times 30 (this provides the number of days’ payments the company has in cash).
- An illustration is: $100,000 cash ÷ $500,000 monthly payment = 20%. 20% times 30 days = 6 days cash on hand.
- Another illustration is: $20,000 cash ÷ $500,000 monthly payments = 4%. 4% x 30 days = 1.2 days cash on hand.
The results can get confusing because there might not be a comparable standard to measure this against. For instance, we could all agree that one month cash is excessive, just as one week might be too much, considering the nature of the business. For instance, a manufacturing company with cash that could cover five days’ payments might be adequate; but a web-based business with one day’s cash might be excessive because all payments are received with order, which is basically before shipment. That company would not really need much of a cash balance at all.
Another thing is: When measuring the payments due you would need to include expense items not yet booked such as anticipated payroll, and this becomes very cumbersome. Further, the only businesses I know that do this are those very tight in cash, doing it out of necessity. These companies are already on watch lists and ratios do not serve much purpose in those cases.
I would stick with the working capital ratio because it has stood a test of time with its meaning and usage, and let it go at that. If you use this ratio, then charting the weekly or monthly changes is what I would watch.
I tried to keep my ratio listing simple, and purposely left this ratio out, but decided to add it in now, so you could be privy to my thoughts and comments, which I hope provide insights that could help you further understand the ratios and their applications, uses and meaning – and in the case of the quick ratio, lack of relevance.
