Balance Ratios

A ratio is the quotient between magnitudes that have a certain relation and for this reason are compared. For example, if you divide the net profit obtained by the company by the amount of owned resources of that same company you obtain the ratio of profitability of the owned resources.

Profitability of Owned Resources  =        net profit
   owned resources

The ratios are almost never studied alone, but with the company of others:

• ratios of the same company to be able to study its evolution
• ideal ratios of general type to prove in which situation is at the present the company with relation to what is considered as ideal. For example, if the consideration is that the ideal profitability is that in which the own resources are of 14% and the company which you are studying has it on an 8%, it indicates that the company is obtaining a low profitability
• ideal ratios of  a sector type to prove that the company is obtaining the profitability that it should, in function of the economic sector in which it operates. For example, if the company obtains an 8% of profitability from its own resources, but the sectors ideal is 10% which means that this company is obtaining a low profitability.

There are an infinity of ratios which means that for each company in function of its specific situation and of analysis objectives, you will have to select the most ideal ratios for the situation in question.

The following are the main ratios for studying the liquidity, indebtedness, efficiency of assets and the terms to pay and to collect. For those ratios that are possible, we will indicate which is the desirable general average value.

Liquidity – to diagnose the liquidity situation of a company, that is, the possibility to confront its payments, you can use the following ratios:

• Liquidity ratio is equal to the current assets, divided by the short-term collectibles:
  Liquidity ratio =        current assets
  Short-term collectibles

For the company not to have problems with the liquidity, the value of the liquidity ratio has to be higher than 1. In case this ratio is less than 1, it indicates that the company is in danger of suspending its payments.

If the liquidity ratio is higher than 1 it can mean that you have lazy current assets and by it you will lose profitability.

Treasury ratio – is equal to the realizable plus the available, divided by the short-term collectibles: 

  Treasury ratio =  realizable + available
                              Short-term collectibles  

For not to have problems of liquidity, the value the ratio has to be of approximately 1. If it is less than 1, the company may suspend its payments. If the treasury ratio is higher than 1, it indicates the possibility of having an excess of liquid assets, and by it you are losing profitability.

If a company has liquidity ratio equal to 2 (correct), but if the treasury ratio is 0.3 (danger of suspending payments) it indicates that the company may suspend its payments due to an excess in the inventory and for lacking of collectibles and available

• Ratio of available is equal to he available divided by the short-term collectibles:

• Ratio  of available =             available
•                Short-term collectibles

• It is difficult to estimate an ideal value for the ratio, due that the available fluctuates along the year and because of it, you have to take an average value. However, it can be indicated that if the value of the ratio is low, you may have problems to attend the payments. On the contrary, if the ratio of available increases too much, there can be more available and due to it, to lose profitability of the same.

Indebtedness – ratios of indebtedness are used to diagnose about the quantity and the quality of the debt that a company has, as to also prove up to what point one can obtain enough earnings to support the indebtedness financial burden.

• ratio of indebtedness is equal to the total of the debts divided by the liabilities:

• Ratio of indebtedness =   total debts
•   total liabilities

The optimum value for this ratio is situated between 0.5 and 0.7. In case of being higher than 0.7 it would indicate that the volume of debts is excessive and the company is losing financial autonomy to a third party or what is the same, it is losing capital.

If it is lower than 0.5 it can happen that the company has an excess of own resources.

• Ratio of financial expenses. There are ratios, that in spite of requiring data from the operation account, permits to prove if the company can support the indebtedness that it already has.
• One of them is that which is calculated by dividing the financial expenses by the sales figures:
•   Ratio of financial expenses = financial expenses
•                     Sales

• When this ratio is higher than 0.05, it indicates that the financial expenses are excessive. When the value is between 0.04 and 0.05 it is an indicator of precaution and when it is than 0.04 it means that the financial expenses are not excessive in relation to the sales figures.

Such as indicated, there are patterns of a general type.

Rotation of assets – rotation ratios allow to study the yields obtained from the assets. They are calculated by dividing the sales by the corresponding assets. The ideal value for the rotation ratios is for them to be as high as possible.

Let us see the most used:

• rotation of fixed assets is obtained by dividing the sales by the fixed assets:

• Rotation of fixed assets =      sales
•   fixed assets

• The greater the value of this ratio will indicate that more sales are generated with the fixed assets.

• rotation of current assets, to find its value one must divide the sales by the fixed assets:

• Rotation of current assets =      sales
•      current assets

rotation of inventories is obtained by dividing the sales by the value of the inventories:.

• Rotation of inventories =       sales
  Inventories

As with the former ratios, when the rotation of inventories, it will mean that more sales are generated with less investment (in this case inventories). For the ratio to be more useful, you have to put the sales at the cost price, due that the inventories are valued in such a way:

  Rotation of inventories =  sales at cost price
        Inventories

The study of rotation ratios is done by analyzing its evolution during several years. The ideal situation is for the rotation ratios to increase. In this way one will precise of less investment in assets to sell. In this way, by having less assets there will be less liabilities and more efficient will the company be. Lesser assets will imply a lower cost of the same.

Collection and payment terms – these ratios serve to prove the evolution of the collection and payment policies to clients and suppliers, respectively.

• ratio of collection term indicates the average number of days that it takes to collect from the clients. It is calculated by dividing the clients balance, items to collect and items discounted pending to empire, by the annual sales and this multiplied by 365:

Collection term = clients + items to collect + items discounted pending to expire x 365
    Sales

In the numerator of the ratio you have to include all the clients debts. The lesser the ratio is it will indicate that you are collecting quicker from the clients.

• ratio of payment term is calculated by dividing the balance of suppliers by the annual purchase and this multiplied by 365. It reflects the average number of days that it takes to pay all the suppliers:

• Payment term =   suppliers  x  365
•         Purchases

The greater the value of this ratio, the longer it takes to pay the suppliers, thus obtaining more funding which is positive. However, from the former situation we have to distinguish that in which a delay In payments is produced, against what was agreed upon with the suppliers. This last situation is totally negative by the lack of formality that it reflects and by the bad prestige that it brings.

Beginner Money Investing Economical and Financial Analysis of a Company Statement of source and application of funds Balance Ratios Analysis of the Operating Account Profitability Analysis Financial Analyzing