Ratios and Formulas in Customer Financial Analysis

Ratios and Formulas in Customer Financial Analysis

Financial statement analysis is a judgmental process. One of the primary objectives is identification of major changes in trends, and relationships and the investigation of the reasons underlying those changes. The judgment process can be improved by experience and the use of analytical tools. Probably the most widely used financial analysis technique is ratio analysis, the analysis of relationships between two or more line items on the financial statement. Financial ratios are usually expressed in percentage or times. Generally, financial ratios are calculated for the purpose of evaluating aspects of a company's operations and fall into the following categories:

* liquidity ratios measure a firm's ability to meet its current obligations.

* profitability ratios measure management's ability to control expenses and to earn a return on the resources committed to the business.

* leverage ratios measure the degree of protection of suppliers of long-term funds and can also aid in judging a firm's ability to raise additional debt and its capacity to pay its liabilities on time.

* efficiency, activity or turnover ratios provide information about management's ability to control expenses and to earn a return on the resources committed to the business.

A ratio can be computed from any pair of numbers. Given the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. A standard list of ratios or standard computation of them does not exist. The following ratio presentation includes ratios that are most often used when evaluating the credit worthiness of a customer. Ratio analysis becomes a very personal or company driven procedure. Analysts are drawn to and use the ones they are comfortable with and understand.

Liquidity Ratios

Working Capital

Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.

* Formula

Current Assets

- Current Liabilities

Acid Test or Quick Ratio

A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business's quick ratio will be lower than its current ratio. It is a stringent test of liquidity.

* Formula

Cash + Marketable Securities + Accounts Receivable

Current Liabilities

Current Ratio

Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business's current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.

* Formula

Current Assets

Current Liabilities

Cash Ratio

Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.

* Formula

Cash Equivalents + Marketable Securities

Current Liabilities

Profitability Ratios

Net Profit Margin (Return on Sales)

A measure of net income dollars generated by each dollar of sales.

* Formula

Net Income *

Net Sales

* Refinements to the net income figure can make it more accurate than this ratio computation. They could include removal of equity earnings from investments, "other income" and "other expense" items as well as minority share of earnings and nonrecuring items.

Return on Assets

Measures the company's ability to utilize its assets to create profits.

* Formula

Net Income *

(Beginning + Ending Total Assets) / 2

Operating Income Margin

A measure of the operating income generated by each dollar of sales.

* Formula

Operating Income

Net Sales

Return on Investment

Measures the income earned on the invested capital.

* Formula

Net Income *

Long-term Liabilities + Equity

Return on Equity

Measures the income earned on the shareholder's investment in the business.

* Formula

Net Income *

Equity

Du Pont Return on Assets

A combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company