Working With Common Financial Ratios

Now that we have a basic understanding of the various financial statements we can begin to analyze those statements. Financial statement analysis is often done using ratios. Below we will present several ratios helpful in managing working capital. It's key to remember that managing working capital requires a balance between having to little cash and holding too much.

Current Ratio

The current ratio is similar to the calculation for working capital. The equation is:

Current Ratio = Current Assets / Current Liabilities

This equation at a minimum should be equal to 1. Numbers less than 1 mean that short term liabilities are greater than short term assets. This is a sign that a company is in desperate need of additional working capital. The higher this number is above 1, the more able a company is to meet their short term liabilities.

However, if the number is too high, it could be a sign that your business has too much capital tied up in current assets. Since current assets often have a low return you may need to look into ways to reduce current assets and invest capital in longer term, higher return assets. A ceiling current ratio will change from company to company.

Quick Ratio or Acid Test

This is a common ratio used in finance and accounting to determine short term financial health. It is similar to the Current Ratio, but is a more stringent and pragmatic test of a company's ability to meet their short term financial obligations. The difference between the current and quick ratio is that the latter only incorporates current assets that can be quickly converted to cash at close to their book values. The equation is:

Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / (Current Liabilities)

In this equation, assets such as inventories and supplies are not included in the top part of the equation. Although inventories are considered current assets, they often cannot be liquidated in a short period of time without substantial discounts. Cash, securities and receivables on the other hand can be liquidated quickly and liquidated at their book values.

This makes the Quick Ratio a good ratio to realistically analyze a company's short term financial health.

The analysis of the result is similar to the current ratio where values below 1 signal serious cash flow problems requiring immediate action. The higher the value is above 1, the healthier the short term financial outlook. However numbers exceeding 3 or 4 could be a sign that your company is holding too many current assets.

Corrective Measures For Poor Liquidity Ratios

When the ratios above fall below or above healthy levels, owners and managers need to take action to correct short term capital levels. If the problem is simply too much cash on hand, the correction simple. Invest the cash in longer term assets in order to boost returns. However, if the issue is that organization doesn't have enough current assets or has too much capital wrapped up in accounts receivable or inventories, the correction is more complicated.

This is where asset based financing becomes valuable, and is the subject of our next course. Click here to go to our Asset Based Finance Course

The Inventory Turnover Ration

A very important part of working capital management is managing inventory levels. We will discuss this subject in detail in a subsequent section, but will introduce a key inventory management ration now. The inventory turnover ratio is:

Inventory Turnover = Cost of Sales / Average Inventory

Average inventory can be calculated like this:

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

This measures how fast a company is able to sell their inventory. The higher this number, the faster a company can sell through their finished goods. This is important because as we have discussed previously having too many current assets on hand can result in poor returns for investors. Most firms are constantly seeking to increase their inventory turnover rate in order to run the company as efficiently as possible. However, a company's inventory turnover rate can be too low. This could be a sign that they are carrying too little inventory and need to boost inventory levels.

Now we can work through an example. Our example will involve analyzing a company's inventory turnover over the course of a year. Here are the numbers we need:

Annual Cost of Goods Sold = $658,000
Beginning Inventory = $70,230
Ending Inventory = $75,500

First we calculate the average inventory:

($70230+$75500) / 2 = $72865

Now we can calculate inventory turnover which is:

$658000 / $72865 = 9.03

Once you know your inventory turnover ratio you can easily calculate the average number of days it takes you to turn over your inventory. By this we mean, on average, how long does it take an input to your company to be sold. The calculation is below.

Average days to sell the inventory = 365 / Inventory Turnover Ratio

What Level Of Inventory Is The Right One

All of the figures above will vary greatly by industry. Industries that experience predictable sales patterns and low to medium priced products will often be able to hold less inventory than industries with more fluctuation in sales and expensive products.

Competitive Ratio Analysis.

The best way to determine whether your ratios are too high or too low is to purchase industry reports. Most industries publish periodic reports that contain industry averages for many of the ratios mentioned above.