Financial Ratios

Debt to equity ratio: Debt/Owners' Equity—indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity.

Debt ratio: Debt/Total Assets—measures the portion of a company's capital that is provided by borrowing. A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. This ratio is similar, and can easily be converted to, the debt to equity ratio.

Fixed to worth ratio: Net Fixed Assets/Tangible Net Worth—indicates how much of the owner's equity has been invested in fixed assets, i.e., plant and equipment. It is important to note that only tangible assets (physical assets like cash, inventory, property, plant, and equipment) are included in the calculation, and that they are valued less depreciation. Creditors usually like to see this ratio very low, but the large-scale leasing of assets can artificially lower it.

Interest coverage: Earnings before Interest and Taxes/Interest Expense—indicates how comfortably the company can handle its interest payments. In general, a higher interest coverage ratio means that the small business is able to take on additional debt. This ratio is closely examined by bankers and other creditors.

EFFICIENCY RATIOS

By assessing a company's use of credit, inventory, and assets, efficiency ratios can help small business owners and managers conduct business better. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given time period. This information can help management decide whether the company's credit terms are appropriate and whether its purchasing efforts are handled in an efficient manner. The following are some of the main indicators of efficiency:

Annual inventory turnover: Cost of Goods Sold for the Year/Average Inventory—shows how efficiently the company is managing its production, warehousing, and distribution of product, considering its volume of sales. Higher ratios—over six or seven times per year—are generally thought to be better, although extremely high inventory turnover may indicate a narrow selection and possibly lost sales. A low inventory turnover rate, on the other hand, means that the company is paying to keep a large inventory, and may be overstocking or carrying obsolete items.

Inventory holding period: 365/Annual Inventory Turnover—calculates the number of days, on average, that elapse between finished goods production and sale of product.

Inventory to assets ratio Inventory/Total Assets—shows the portion of assets tied up in inventory. Generally, a lower ratio is considered better.

Accounts receivable turnover Net (credit) Sales/Average Accounts Receivable—gives a measure of how quickly credit sales are turned into cash. Alternatively, the reciprocal of this ratio indicates the portion of a year's credit sales that are outstanding at a particular point in time.

Collection period 365/Accounts Receivable Turnover—measures the average number of days the company's receivables are outstanding, between the date of credit sale and collection of cash.

SUMMARY

Although they may seem intimidating at first glance, all of the aforementioned financial ratios can be derived by simply comparing numbers that appear on a small busi-ness's income statement and balance sheet. Small business owners would be well-served by familiarizing themselves with ratios and their uses as a tracking device for anticipating changes in operations.

Financial ratios can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies. Ratio analysis, when performed regularly over time, can also help small businesses recognize and adapt to trends affecting their operations. Yet another reason small business owners need to understand financial ratios is that they provide one of the main measures of a company's success from the perspective of bankers, investors, and business analysts. Often, a small business's ability to obtain debt or equity financing will depend on the company's financial ratios.

Despite all the positive uses of financial ratios, however, small business managers are still encouraged to know the limitations of ratios and approach ratio analysis with a degree of caution. Ratios alone do not make give one all the information necessary for decision making. But decisions made without a look at financial ratios, the decision is being made without all the available data.