Financial Ratios
Did you know that by looking at a company's set of accounts you can tell how long,
on average, that company takes to collect its debts, as well as how long it takes
them to pay their suppliers?
A financial ratio is a relationship that indicates something about a company's
activities, such as the ratio between the company's current assets and its current
liabilities or between its debtors and its turnover.
The basic source of these ratios is the company's profit & loss account
and balance sheet that contain all kinds of important information about that
company. The ratios really help to bring those details to light and identify
the financial strengths and weaknesses of the company.
When assessing ratios, it is important that the results are compared with other
companies in the same industry and not to be taken in isolation. What may seem
like a poor ratio at first glance may well be normal for that industry and,
of course, the reverse applies, in that what may seem a good ratio on its own,
could be below average for that industry.
The following information will outline important ratios in the Equifax credit
report, looking at the formula and the interpretation of those ratios.
Current Ratio
Current Assets
Current Liabilities
One of the most universally known ratios, which reflect the Working Capital
situation, indicates the ability of a company to pay its short-term creditors
from the realisation of its current assets and without having to resort to selling
its fixed assets to do so.
Ideally the figure should always be greater than 1, which would indicate that
there are sufficient assets available to pay liabilities, should the need arise.
The higher the figure the better.
For those industries such as transport where the majority of assets are tangible
fixed assets, then a figure of 0.6 would be acceptable. In retail and manufacturing
we would expect figures between 1.1 to 1.6; in wholesale and construction 1.1
to 1.5 and motor vehicles 1.2 to 1.6. Generally where credit terms and large
stocks are normal to the business, the current ratio will be higher than, for
example, a retail business where cash sales are the norm.
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Liquidity Ratio
Current Assets - Stock
Current Liabilities
This ratio indicates the ability of a company to pay its debts as they fall
due. It is generally considered to be a more accurate assessment of a company's
financial health than the current ratio as it excludes stock, thus reducing
the risk of relying on a ratio that may include slow moving or redundant stock.
Figures of this ratio are lower than the current ratio. Supermarkets can, for
example, easily survive on ratios as low as 0.4 with cash being received for
goods sold, before the goods are actually paid for. Plant hire contractors would
also expect ratios as low as 0.6 to 0.8. Clothing retailers also operate at
very low levels, with average figures being between 0.2 and 0.6 and retail as
a whole between 0.3 and 0.7. In manufacturing figures between 0.7 and 1.1 are
seen as acceptable and for wholesalers 0.7 to 1.0. Construction should operate
at between 0.6 and 1.0.
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Stock Financing Ratio
Stock + Work in Progress
Current Assets - Current Liabilities
Compares stock and work in progress to working capital and therefore shows how
sensitive working capital is to a fall in stock value.
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Solvency Ratio
Shareholders Funds x 100
Total Assets
This ratio measures if the total liabilities of a business (both secured and
unsecured) are too high, indicating a possible over dependency on outside sources
for long-term financial support. By comparing shareholders funds to total assets
we can produce a confidence factor for unsecured creditors to the business.
As a general rule, the higher the result the better, although results for new
companies are distorted as the business would not have had the trading history
to develop high levels of net worth. An average score would be between 30% and
50% whilst poor performers can generate scores of below 10% or even have a negative
score. Exceptionally performing businesses could reach a value in excess of
65%.
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Insolvency Ratio
Shareholders Funds
Loss
Compares a company's losses to its shareholders funds, indicating (in years)
the time it will take for the company to become insolvent due to lack of profit,
rather than due to cash flow liability. It assumes that the company will continue
to make the same losses.
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Collection Period
Debtors x365 (days)
Turnover
Measures the length of time a company takes to collect its debts and is measured
in days. In general terms the figure indicates the effectiveness of the company's
credit control department in collecting monies outstanding.
Apart from strictly cash businesses like supermarkets with virtually zero debtors,
normal payment terms are at the end of the month following delivery, giving
an average credit of between 6 and seven weeks. Clothing retailers show some
of the lowest figures with averages of around 7 days. In manufacturing average
figures are around 63 days, with 42 being experienced at the top end and 84
days at the lower end. Average for wholesalers is around 56 days, whilst in
construction the figures are lower, at around 45 days.
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Creditor Days
Creditors x 365 (days)
Turnover
This ratio measures the length of time it takes a company to pay its creditors.
Generally the average figure is around 30 days. In the construction industry
the average is around 31 days, rising to 54 days at the bottom end and down
to 17 days at the top. For wholesalers the average rises to 37 days, with top
and bottom figures being 18 and 61 days respectively. For retail the average
figure drops to 23 days with 40 days being in the bottom sector. For food retailers
as low as 8 - 12 days is the norm. In manufacturing averages tend to be around
37 days, with the worst performers rising to 55 days and the best showing creditor
days of around 22 days.
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Stock/Turnover
Turnover
Stock
Measures the number of times a company converts its stock into sales during
the year. When examining this ratio it should be borne in mind that different
companies will have varying levels of stock turnover depending on what they
produce and the industry they operate in.
Low figures are generally poor as they indicate excessively high or low moving
stocks. At one end of the scale, and apart from advertising agencies and other
service industries, ready mixed concrete companies probably have one of the
better stock/turnover figures.
At the other end companies that maintain depots of finished goods and replacement
parts will have much poorer figures. For example, a manufacturing company with
stock/turnover ratio of around 25 - 30 would be reasonable, decreasing with
the larger and more complex the goods being made. For retail and wholesale,
average figures would be lower at around 9 - 10. For construction, average stock/turnover
figures would be around 16 and for industries such as transport, where overall
stock figures are low, it would produce results of around 80 - 90.
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Asset Turnover
Turnover
Net Assets
The asset turnover indicates how effectively a company utilises its investment
in assets. It is a measure of how efficient the company has been in generating
sales from the assets at its disposal. A low figure would suggest either poor
trading performance (which can be evaluated by the profit margin, sales per
employee figures) or an over investment in costly fixed assets. The construction
industry shows a mean asset turnover ratio of 1.6, with the poorer performers
averaging 0.6 and the better companies showing an average of 2.6. The retail
sector has an average asset turnover of 1.9, with poorer performers in the sector
averaging 0.8 and the better ones showing an average of 3.2.
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Sales/Fixed Assets
Turnover x 100
Tangible fixed assets
A measure of how effectively Fixed Assets (e.g. Property, plant, equipment)
are being used to generate sales.
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Sales/Total Assets
Turnover x 100
Total Assets
A measure of how effectively a company uses its total assets to generate sales.
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Fixed Asset Investment
Tangible Fixed Assets
Total Assets
Shows what proportion of the companies assets are profit generating fixed assets
(e.g. plant and machinery).
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Monthly/Turnover
Turnover
12
Expresses average monthly sales.
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Gearing Ratio
(Long Term Borrowings + Short term Loans + Overdraft) - Cash x
100 Shareholders Funds
Gearing is a comparison between the amount of borrowings a company has to its
shareholders funds (net worth). The result of the calculation will show as a
percentage the proportion of capital available within the company in relation
to that owed to sources outside the company. Lower figures are more acceptable,
showing that the company is predominantly financed by equity whilst high gearing
shows an over reliance on borrowings for a significant proportion of the company's
capital requirements.
High gearing is significantly more dangerous at times of high or rising interest
rates and also low profitability. Businesses that rely on a great deal of tangible
assets (such as heavy manufacturing) or have to replace fixed assets more frequently
than other industries are expected to have higher gearing figures.
The transport industry shows an average gearing level of 150%, with the poorer
performers suffering levels up to 380%. The service sector has an average gearing
level of 100%, with the upper quartile of companies showing negative gearing
(i.e. surplus of cash over borrowing). The construction industry, where borrowing
is usually taken out against work in progress as well as tangible fixed assets
such as plant and machinery, shows an average of 130% gearing, with the better
performers averaging 30% and the poorer performing businesses showing gearing
levels in excess of 400%.
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Total Debt
Current Liabilities + Long Term Liabilities
Shareholders Funds
This ratio compares total liabilities to shareholders funds. It is useful when
considered over a period of time, i.e. in successive years' accounts. An increasing
ratio would indicate that borrowing is making a higher contribution to the capital
base of the business than shareholders funds. This may cause problems, particularly
if profit margins are also in decline.
The manufacturing sector shows an average total debt ratio 1.4, with the lower
quartile companies averaging around 3.4 and the upper quartile showing a ratio
of 0.4. The retail sector shows an average of 1.1, with the better performers
in retail averaging 0.2: the construction industry averages around 1.5, with
the upper quartile averaging around 0.25.
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Current Debt
Current Liabilities
Shareholders Funds
This ratio compares current liabilities to shareholders funds and is a useful
ratio when considered over a period of time, i.e. in successive years' accounts.
An increasing ratio would indicate that borrowing is making a higher contribution
to the capital base of the business than shareholders funds. This may cause
problems, particularly if profit margins are also in decline.
The manufacturing sector shows an average current debt ratio of 1.1, with the
lower quartile companies averaging around 3.0 and the upper quartile showing
a ratio of 0.3. The retail sector shows an average of 0.9, with the better performers
in retail averaging 0.1: the construction industry averages around 1.3, with
the upper quartile averaging around 0.20.
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Total Long Term Debt
Long Term Liabilities
Total Assets - Current Liabilities
Shows what proportion of permanent capital has been provided by long term lenders.
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Shareholders Equity
Shareholders Funds
Long Term Liabilities
Shows how many pounds worth of shareholders funds exist for every pound worth
of long term debt.
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Credit Gearing
Credit Limit x 100
Shareholders Funds
Expresses the suggested credit limit as a percentage of shareholders funds.
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Profit Margin (Return on Sales)
Profit Before Tax x 100
Turnover
Measures the margin of profitability on sales throughout the year. This is the
main indicator when measuring the efficiency of the operation, a very good indicator
of the business's ability to withstand falling prices, rising costs or declining
sales.
A normal figure for a manufacturing industry would be between 6% and 8%, while
high volume/low margin activities like food retailing can run very satisfactorily
at around 3%. Retailers generally will have a lower profit margin than most
industries.
Highest margins of all are usually experienced in service industries where margins
above 10% are enjoyed.
The percentage should be relatively constant and any reason for decline investigated.
Reasons for change could be a reduction in selling prices or increase in cost
of sales.
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Profit/Capital Employed (Return on Capital Employed)
Profit before Tax x 100
Total Assets - Current Liabilities
This ratio measures whether or not a company is generating adequate profits
in relation to the funds invested in it and is a key indicator of investment
performance. A business could have difficulty servicing its borrowings if a
low return is being earned for any length of time. In manufacturing we would
expect to see figures in excess of 10% rising to over 25% at the top end. In
retail lower figures would be experienced, ranging between 5% and 15%. Construction
figures show an average of about 7% increasing to over 35% for the top performers.
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Profit/Assets
Profit Before Taxation x 100
Total Assets
This is a useful indicator as to whether a business is using its assets well
and getting the most value out of capital expenditure. Companies using their
assets well will have a relatively high return, while those less well-run businesses
will have a relatively low return.
In manufacturing and transport average figures run at about 4% rising to around
10% in the best companies. In construction average figures are lower at around
2% and for wholesalers and retailers we would expect figures between 2% and
8% as an average.
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Return on Shareholders Funds
Profit Before Tax x 100
Shareholders Funds
Indicates whether or not a company is generating adequate profits in relation
to the resources invested in it by shareholders.
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Employee Ratios
The employee ratios show the productivity of the company's employees and can
be of value if yearly fluctuations are examined within the same industry type.
| Profit/Employee: |
Profit Before Tax
No. of Employees |
| Sales/Employee: |
Turnover
No. of Employees |
| Capital Employed/Employee: |
Total Assets - Total Liabilities
No. of Employees |
| Fixed Assets/Employee: |
Tangible Fixed Assets
No. of Employees |
| Shareholders Funds/Employee: |
Shareholders Funds
No. of Employees |
| Export/Employee: |
Export
No. of Employees |
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