What do Performance Ratios mean?

Performance ratios (also known as accounting ratios or financial ratios) are indices of relationships among various financial flows and stocks of your company as recorded by your financial reporting system (your "books" or accounting system).  Your balance sheet shows the values of financial stocks (assets, liabilities, and equity) for your company at any given time and your income statement shows the values of financial flows (income and expenses) that resulted from the operations of your company over a given period of time.

Financial and business analysts use these ratios to measure various performance aspects of your company and to compare these aspects of your company to those of other companies.

There are two comparison methods that are of special interest: trends analyses and industry standards.

Trends analyses compare ratios from your company across several successive periods.  Changes in the same ratio over the comparison periods can indicate important changes taking place in the financial operations and results of your company.

Various services develop, through survey and through analysis of public records, average or median values for performance ratios for all companies within various industry classifications.  These are the industry standard ratios.  Using industry standards, you can measure the financial state and past performance of your company against similar companies.

You should be careful in applying industry standard ratio analysis.  First, every company is unique, and has distinctive characteristics: capabilities, products, resources, markets, etc.  These affect values of company performance ratios.  Industry standard ratios are not necessarily the standards your company should strive for.  Second, if you are striving for the industry standard in performance, as indicated by industry standard performance ratios, you are aiming at the middle of the competitive pack instead of aiming for the top.

Finally, cross-industry comparisons are very risky.  It is expected that different business categories will have wildly varying ratios.  For instance, retail and wholesale companies typically will show high inventory investment ratios while service companies may have no inventory investment at all.

If you are in any doubt as to the significance of the ratios calculated, you should consult a professional to help you in interpretation.

Liquidity Ratios (Working Capital Ratios)

Liquidity ratios measure the ability of your company to meet current liabilities such as trade accounts payable, short-term loan payments, payrolls, and so on.

Current Ratio

The Current Ratio (also known as the Working Capital Ratio) measures current assets against current liabilities.  A Ratio less than 1.00 indicates that your business owes more in the short term than it has short term assets (usually cash, accounts receivable, and inventory) to cover.  Short term is usually considered less than thirty days.  It is called working capital because it measures your liquid assets (assets that can be turned into cash quickly) against the debts (usually trade accounts payable) incurred in the operation of your business.  A decreasing current ratio indicates that your company is less able to meet immediate cash needs over time.

Quick Ratio (Acid Test)

The Quick Ratio (sometimes called the Acid Test) is the same as the Current Ratio except it eliminates inventory from the current assets on the assumption that inventory can not necessarily be converted to cash immediately.  A decreasing quick ratio indicates that your company has less cash available just as the current ratio; however, it may further indicate that your inventory is increasing relative to other forms of current assets such as cash or accounts receivable.

Efficiency Ratios

Efficiency ratios measure the rate (or efficiency) with which your company turns inventory, and other assets into revenue.

Inventory Analyses

For wholesale, distribution, and retail businesses stock inventory is the primary means of revenue production.  An important measure of performance, then, is the rate at which the company  turns inventory into revenue.  Inventory analyses can be very tricky since there are multiple ways to value inventory; LIFO, FIFO, weighted average, among others.  The valuation method heavily influences the result of inventory analyses calculations.  Fortunately, there tend to be large numbers of similar businesses using the same valuation methods.  However, be aware that a change in inventory valuation method may result in great changes in results.

There are many companies for which inventory analysis is not at all applicable.  Many service providing companies, for instance business consulting companies, architects, physicians, and so on, produce revenue by selling their time and skills instead of selling goods.  For these kinds of companies

Average Inventory Investment Period

The average inventory investment period measures the number of days it takes the company to realize revenue from its inventory investment.  In other words, it measures the amount of time, on average, inventory sits in a company's warehouse not earning money.  An increasing inventory investment period can indicate that your inventory is filling up with slow-moving products.

Inventory to Sales Ratio

Turnover Analysis

Labor Cost Analyses

For companies in which the cost of labor is an equal or greater part of the total cost of production, labor cost analyses are of equal or greater importance than physical inventory analyses.  These ratios measure the ability of the company to turn workers' time and skills into revenue and are especially important for service providers.

Payroll as a Percent of Sales

Payroll as a percent of Net Income

Accounts Receivable Ratios

Average Collection Period

Accounts Receivable to Sales Ratio

Fixed Assets Turnover

Total Assets Turnover

Profitability Ratios

Profitability ratios measure the effectiveness of your company in turning revenue into profit and into returns to investors or owners.

Gross Profit Margin Ratio

Net Profit Margin (Net Profit Percentage)

Operating Profit Percentage

Return on Assets

Return on Equity

Solvency Ratios

Debt to Equity

Debt to Assets

Coverage of Fixed Costs

Interest Coverage