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Financial Ratios Overview

The financial accounting system, as defined in the U.S. and in some other countries by Generally Accepted Accounting Practices (GAAP) maintained by the Financial Accounting Standards Board (FASB), provides the primary method of performance measurement for most American businesses. In general, the system tracks broad measures of periodic business activity through its Income Statement, and maintains the current financial status of valuable assets, of liabilities of the company in terms of debt owed, and of the net value of the company in terms of owners equity in its Balance Sheet.

This system of business performance measurement has become a standard in American business primarily because U.S. (and other nations') tax laws require that companies provide this information and because equity and other financial markets depend on it as the standard basis of valuation and comparison.

The basic relationships within the accounting system are:

owners equity = (assets - liabilities) + retained earnings (from the Balance Sheet), and
retained earnings = income - expenses ( from the Income Statement).

However, there are many other relationships among the various categories of financial flows and stocks maintained by the system that can serve as indicators of your company's performance. Developed over many decades, these relationships (or ratios) provide company managers and business analysts insights into the results of critical business operations and, being somewhat standardized, allow analysis of the trends of these results and comparison of the results of one company with those of another.

The ratios we have chosen fall into four different categories:

Liquidity Ratios - produce indices that measure the company's relative liquidity, or ability to produce cash immediately (usually within thirty days) to meet its immediate obligations;

Efficiency Ratios - generate indices that measure the company's effectiveness in using its resources to produce income;

Profitability Ratios - produce indices that measure the efficiency of the company in turning income into profit, and

Solvency Ratios - yield indices that indicate the company's ability meet its existing financial obligations.

Data Used in Calculations

Income statement data used in calculating ratios are for a defined period of time: a week, a month, a year. Be careful in entering data that the balance sheet data entered is as of the end of the period covered by the income statement data entered. Otherwise resulting ratios will be invalid.

We assume that your company uses the accrual method of accounting, not the cash basis method. The cash basis method does not track some data such as accounts receivable nor accounts payable. (For a discussion of these methods see http://en.wikipedia.org/wiki/Accounting_methods.

A Cautionary Note Concerning Ratios

While financial indicators such as these ratios can be a very powerful tool in identifying business operations trends and in the comparison of performance results among similar businesses, they do have serious limitations. For instance, financial ratios assume some history of business operation. Therefore, they cannot adequately measure performance of startups that have little or no operating history. Also, because of the diversity of operational methods and of resources utilization among various companies, especially those in different industries, these comparisons become less and less informative as they encompass larger and larger business populations.

Finally, the fundamental assumption in using these indicators is that the data on which they are based accurately represent contemporaneous results of the business' operation; something that is not always the case.

Consider these ratios to be indicative and not as definitive.

Balance Sheet

Your Balance Sheet is a current snapshot of the value of your company. It shows the values of the various categories of assets owned by your company, the values of the various categories of debts (or liabilities) that your company owes, and the value of the ownership stake (equity) in the company. Various categories of values used here are:

Current Assets:

This is the total money value of all the liquid assets of your company. Liquid generally means that the assets are cash or could be turned in to cash within thirty days. In most cases this is cash in the bank and accounts receivable.

Current Liabilities:

This is the total money value of all the amounts owed by your company in trade and any other amounts owed within the next thirty days. In most cases this is accounts payable, credit card payments due, and loan payments due within thirty days.

Total Inventory:

This is the total money value of your inventory at the end of the period for which you are calculating ratios. There are several methods of inventory valuation allowed by the IRS. In general, Beginning Inventory + Net Inventory Purchases - Cost of Goods Sold (COGS) = Ending Inventory,

Accounts Receivable:

This is the total money value owed and not yet paid to your company by customers to whom you have delivered products or services.

Fixed Assets:

The number to be entered for Fixed Assets is the total money value of assets owned by your company and not intended for resale. Fixed assets may be tangible or intangible. Tangible fixed assets may include furniture, fixtures, tools, equipment, vehicles and buildings. Intangible assets might include copyrights, patents, licenses, franchises, leases, subscription lists, and goodwill. This value should be net of depreciation taken, if any.

Total Assets:

Assets are those things owned by your company: cash, accounts receivable, other debts, buildings, equipment, etc. This is the total value of all the things owned. It should be a major total at the bottom of the Assets section of your balance sheet. This amount should be less any depreciation accrued.

Total Debt:

This number is the total amount owed by your company to others. It includes trade accounts payable, short term and long term loans owed, accrued taxes, accrued payroll, etc. Also called Total Liabilities, it should be a major total at the bottom of the Liabilities section of your balance sheet.

Owners Equity:

This number is the total ownership value of your company. In general, it is total assets minus total liabilities. It should be a major total at the end of the Equity section of your balance sheet.

Income Statement

Your Income Statement (also called Profit and Loss Statement, P&L, or Operating Statement) shows the financial results of the operations of your company over a given period of time. This Statement categorizes these values based on whether they are income or expenses and on how they originated. Categories of values in which we are interested here are:

Sales:

Sales is the category that provides most of the income for the majority of for-profit companies. Sales generally result from your company selling product or service to a customer and receiving cash or a promise of cash in return. It is the total value of that cash and promised cash for a given period that is recorded in this category. If your company takes payment "in kind" then the value of all promised "in kind" payments should be included.

Cost of Goods Sold (COGS):

Cost of Goods Sold (COGS) is the total amount that your company paid to acquire the goods you sold in the applicable accounting period. You can roughly compute this total: Total Inventory at the beginning of the period + Inventory purchased during the period - Total Inventory at the end of the period.

Gross Profit:

Gross Profit is the remainder when the all costs directly related to sales are subtracted from total sales. Calculated as sales minus all costs directly related to those sales. These costs can include manufacturing expenses, raw materials, labor, selling, marketing and other expenses

Interest Expense:

This amount is the total that your company has paid during the subject period for interest on borrowed funds.

Operating Income:

This is the amount your company earned after deducting all expenses except interest payments and income taxes. Also called operating profit or EBIT (earnings before interest and taxes).

TAXES:

The expense for taxes paid on company income during the subject period.