Income Statement Ratio
Analysis
The Balance Sheet and
the Statement of Income are essential, but they are only the starting points
for successful financial management. Apply Income Statement Ratio Analysis to
Financial Statements to analyze the success, failure, and progress of your
business.
Ratio Analysis enables
the business owner/manager to spot trends in a business and to compare its
performance and condition with the average performance of similar businesses in
the same industry. To do this compare your ratios with the average of
businesses similar to yours and compare your own ratios for several successive
years, watching especially for any unfavorable trends that may be starting.
Ratio analysis may provide the all-important early warning indications that
allow you to solve your business problems before they destroy your business.
The following
important State of Income Ratios measure profitability:
Gross Margin Ratio
This ratio is the percentage
of sales dollars left after subtracting the cost of goods sold from net sales.
It measures the percentage of sales dollars remaining (after obtaining or
manufacturing the goods sold) available to pay the overhead expenses of the
company.
Comparison of your
business ratios to those of similar businesses will reveal the relative
strengths or weaknesses in your business. The Gross Margin Ratio is calculated
as follows:
Gross Profit
Gross Margin Ratio =
_______________
Net Sales
(Gross Profit = Net
Sales - Cost of Goods Sold)
Net Profit Margin
Ratio
This ratio is the
percentage of sales dollars left after subtracting the Cost of Goods sold and
all expenses, except income taxes. It provides a good opportunity to compare
your company's "return on sales" with the performance of other
companies in your industry. It is calculated before income tax because tax
rates and tax liabilities vary from company to company for a wide variety of
reasons, making comparisons after taxes much more difficult. The Net Profit Margin
Ratio is calculated as follows:
Net Profit Before Tax
Net Profit Margin
Ratio = _____________________
Net Sales
Management Ratios
Other important
ratios, often referred to as Management Ratios, are also derived from Balance
Sheet and Statement of Income information.
Inventory Turnover
Ratio
This ratio reveals how
well inventory is being managed. It is important because the more times
inventory can be turned in a given operating cycle, the greater the profit. The
Inventory Turnover Ratio is calculated as follows:
Net Sales
Inventory Turnover
Ratio = ___________________________
Average Inventory at
Cost
Accounts
Receivable Turnover Ratio
This ratio indicates
how well accounts receivable are being collected. If receivables are not
collected reasonably in accordance with their terms, management should rethink
its collection policy. If receivables are excessively slow in being converted
to cash, liquidity could be severely impaired. The Accounts Receivable Turnover
Ratio is calculated as follows:
Net Credit Sales/Year
__________________ =
Daily Credit Sales
365 Days/Year
Accounts Receivable
Accounts Receivable
Turnover (in days) = _________________________
Daily Credit Sales
Return on Assets
Ratio
This measures how
efficiently profits are being generated from the assets employed in the
business when compared with the ratios of firms in a similar business. A low
ratio in comparison with industry averages indicates an inefficient use of
business assets. The Return on Assets Ratio is calculated as follows:
Net Profit Before Tax
Return on Assets =
________________________
Total Assets
Return on
Investment (ROI) Ratio.
The ROI is perhaps the
most important ratio of all. It is the percentage of return on funds invested in
the business by its owners. In short, this ratio tells the owner whether or not
all the effort put into the business has been worthwhile. If the ROI is less
than the rate of return on an alternative, risk-free investment such as a bank
savings account, the owner may be wiser to sell the company, put the money in
such a savings instrument, and avoid the daily struggles of small business
management. The ROI is calculated as follows:
Net Profit before Tax
Return on Investment =
____________________
Net Worth
These Liquidity,
Leverage, Profitability, and Management Ratios allow the business owner to
identify trends in a business and to compare its progress with the performance
of others through data published by various sources. The owner may thus
determine the business's relative strengths and weaknesses.
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