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Financial Ratios for Shop Evaluation

(May 2005) posted on Thu May 05, 2005

Don't neglect these tools in evaluating your company.


By Marty McGhie

You probably spend a lot of time analyzing your business. Far
too many shop owners, however, neglect one of the best ways to
evaluate a company: the use of financial ratios"?including liquidity
ratios, profitability ratios, and activity ratios.

Before getting into the details, let's consider how these ratios
should be used. The most useful analysis is achieved by comparing
the results of your financial analysis over different periods of
time. For example, ratio analysis on your annual financial statements
should be discussed in the context of how things have
changed since the prior year. In addition, comparative analysis
also can be done on a quarterly
and a monthly basis if
you wish to more accurately
track the financial health of
your company.

You can also use financial
ratios to evaluate the
performance of your business
against standards that
have been established in
your company's specific
market niche (to the extent
that the information is
available). Comparing and contrasting the results of your business
with industry norms can be a very useful tool in financial
benchmarking. Keep these thoughts in mind as I take you
through a few ratios that should prove useful.

Liquidity ratios

Liquidity ratios measure the extent to which a company can
quickly liquidate its assets and generate cash in order to cover
short-term liabilities.

Current Ratio = current assets ?? current liabilities

This ratio measures how well a company can manage its shortterm
cash needs. Simply stated, can the company pay its bills? If
this ratio is substantially over 1.0, cash flow will typically be positive
and working capital will be available for the day-to-day business
needs. If, however, this ratio dips below 1.0, cash flow will become
tight and the business may begin to suffer from a cash crunch.

Quick Ratio = quick assets (current assets - inventories)
??current liabilities

The quick ratio is often used by banking and financial institutions
to measure true liquidity. Because inventories are
less easily converted to cash, the quick ratio provides a more
accurate measure of the business's ability to meet immediate
cash-flow demands.

Profitability ratios

Profitability ratios generally show how successful a company is
in terms of generating returns or profits on the investment that
it has made in the business.

Profit Margin = net income ?? sales


Terms:

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