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 Monthly/Turnover Liquidity Ratio Gearing Ratio Stock Financing Ratio Total Debt Solvency Ratio Current Debt Insolvency Ratio Total Long Term Debt Collection Period Shareholders Equity Creditor Days Credit Gearing Stock/Turnover Profit Margin (Return on Sales) Profit/Capital Employed (Return on Capital Asset Turnover Employed) Sales/Fixed Assets Profit/Assets Sales/Total Assets Return on Shareholders Funds Fixed Asset Investment Employee 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. Top 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 beingreceived 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. Top 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. Top 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%. Top 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. Top 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. Top 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. Top 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. Top Asset Turnover Turnover The asset turnover Net Assets 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. Top 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. Top Sales/Total Assets Turnover x 100 Total Assets A measure of how effectively a company uses its total assets to generate sales. Top 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). Top Monthly/Turnover Turnover 12 Expresses average monthly sales. Top Gearing Ratio (Long Term Borrowings + Short term Loans + Overdraft) Gearing is a Cash x 100 comparison Shareholders Funds 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%. Top 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. Top 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. Top Total Long Term Debt Long Term Liabilities Total Assets - Current Liabilities Shows what proportion of permanent capital has been provided by long term lenders. Top Shareholders Equity Shareholders Funds Long Term Liabilities Shows how many pounds worth of shareholders funds exist for every pound worth of long term debt. Top Credit Gearing Credit Limit x 100 Shareholders Funds Expresses the suggested credit limit as a percentage of shareholders funds. Top 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. Top 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. Top 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. Top 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. Top 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 Top