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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.

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By Marty McGhie

This ratio is probably the most popular and widely utilized of all
ratios. The measure of net income generated by sales is always an
important number to focus on when managing a business. This
ratio provides the snapshot of any company's fiscal health.

Return on Assets = net income ?? average total
assets [(beginning assets + ending assets) ?? 2]

This ratio indicates asset utilization by a business in terms of
income generated. For example, if a business increases profitability
from 6% to 8%, that would indicate a positive trend. If,
however, the business doubled its assets in that same year but
only increased profitability by 2 points, the return on assets will
show a negative trend and unfavorable results. This ratio will
identify companies that are purchasing significant assets to
maintain their profit margins.

Return on Equity = net income ?? average shareholders'
equity [(beginning shareholders' equity
+ ending shareholders' equity) ?? 2]

This ratio is very similar to the return on assets. The return
on equity will indicate the measure of profitability as a proportion
of the amount of equity infused into the company. If the
company's owners contribute a significant amount of equity to
the business in order to provide working capital, inventory,
assets, etc., and the profit margin remains the same, this ratio
may indicate that equity is perhaps not being utilized as well as
you would like"?especially if you are the contributor!

Activity ratios

Activity ratios measure a company's ability to utilize cash and
inventory to generate sales.

Accounts Receivable Turnover Ratio = sales ?? average
accounts receivable [(beginning A/R + ending A/R) ?? 2]

In addition to tracking your A/R aging reports, try calculating
the A/R turnover ratio on a regular basis and chart the progress.
While the A/R aging report provides an immediate snapshot of
where your collection efforts should be focused, the A/R turnover
ratio illustrates how effective your collection efforts are.

For example, at the end of a given month, your work on collecting
outstanding accounts might indicate an improvement in
the overall balance of accounts receivable. This is good! If, however,
sales have dropped down in that same month by a larger
amount, the A/R turnover ratio calculation will indicate that collection
efforts need to improve. This ratio presents you with an
overall picture of how well the collection efforts are going in relation
to the increase or decrease of sales in a given month.

Inventory Turnover Ratio = cost of goods sold
??average inventories [(beginning inventories
+ ending inventories) ?? 2]

The inventory turnover ratio offers valuable data regarding the
purchasing levels of inventory. It provides valuable insight regarding
inventory utilization. Like the other ratios, this calculation is
best used when comparing with other periods. If this ratio is
tracked for an extended period of time, you can then begin to target
the turnover ratio desired, and measure results accordingly.

Indicating the trends

Remember: By themselves, these financial ratios serve no useful
purpose"?their job is to indicate trends in the financial position of
your company. Using financial-ratio analysis requires discipline
and some time, but if you use it, you will gain a better understanding
of your business"?which should make you a better manager.

Marty McGhie ( is VP finance/
operations of Ferrari Color, a digital-imaging center with Salt
Lake City, San Francisco, and Sacramento locations.