Ratios and Definitions

FINANCIAL RATIOS, FORMULAS, AND INTERPRETATION

One key element in any financial analysis is the comparison of financial ratios. The usefulness of financial ratios is increased as individual ratios are compared with each other over time. For instance, an analysis that explains a change in the current ratio over the past two years will be more useful to the reader than an explanation of the variance between that company's current ratio and a published industry average current ratio. The use of financial ratios can be an excellent tool in financial analysis; however, mere comparison to industry averages may have limited value.

The primary benefit of financial ratio analysis lies in determining the cause of changes in ratios over time. Industry averages of various ratios can be useful as a beginning benchmark for comparison purposes and as an indication of industry competition. The interpretation of financial ratios provided is not intended to represent all possible interpretations and is only an example of how these ratios may be used. There may be other interpretations of these financial ratios.

PROFITABILITY RATIOS

Ratio Formula What It Means
Return on Assets Net Earnings Before Income ÷ Taxes Total Assets Indicates the profit generated by the total assets employed. A higher ratio reflects a more effective employment of company assets. This ratio is generally stated in terms of percentages (i.e., 10% return on assets).
Return on Equity Net Earnings Before Income Taxes ÷ Total Net Worth Indicates the profit generated by the net assets employed. This ratio reflects the stockholders' return on investment and is generally stated as a percentage. A very high ratio may indicate an undercapitalized situation or conversely, a very profitable company.
Times Interest Earned (Net Earnings + Income Taxes + Interest Expense) ÷ Interest Expense Indicates the company's ability to pay interest expense from operations. A low ratio may indicate an over-leveraged situation and a need for more permanent equity.

LEVERAGE RATIOS

Ratio Formula What It Means
Debt to Equity Total Liabilities ÷ Total Net Worth Indicates the relationship between creditors and owners. Generally, a ratio of three or lower is considered acceptable.
Revenue to Equity Revenue ÷ Total Net Worth Indicates the level of revenue being supported by each $1 of equity. Generally, a ratio of 15 or less is considered acceptable.
Asset Turnover Revenue ÷ Total Assets Indicates the level of revenue being supported by each $1 of assets. By reviewing the trend of this ratio, one can determine the effectiveness of asset expansion
Fixed Asset Ratio Net Fixed Assets ÷ Total Net Worth Indicates the level of stockholders' equity invested in net fixed assets. A higher ratio may indicate a lack of funds for current operations. Usually, a low ratio indicates a more favorable liquidity position; however, off balance sheet financing of equipment may offset this apparent positive indication.
Equity to General and Administrative Expenses Total Net Worth ÷ General and Administrative Expenses Indicates the level of overhead in relation to net worth. Generally, a ratio of 1.0 or more is considered acceptable.
Underbillings to Equity (Unbilled Work + Cost in Excess) ÷ Total Net Worth Indicates the level of unbilled contract volume being financed by the stockholders. Usually stated as a percentage, a ratio of 30% or less is considered acceptable.
Backlog to Equity Backlog ÷ Total Net Worth Indicates the relationship of signed or committed work to total stockholders' equity. Generally, a ratio of 20 or less is considered acceptable. A higher ratio may indicate the need for additional permanent equity.

EFFICIENCY RATIOS

Ratio Formula What It Means
Backlog to Working Capital Backlog ÷ (Current AssetsCurrent Liabilities) Indicates the relationship between signed or committed work and working capital. A higher ratio may indicate a need for an increase in permanent working capital.
Months in Backlog Backlog ÷ (Revenue ÷ 12) Indicates the average number of months it will take to complete all signed or committed work.
Days in Accounts Receivable (Contract Accounts Receivable + Other Accounts ReceivableAllowance for Doubtful Accounts) × 360 ÷ Revenue Indicates the number of days to collect accounts receivable. A lower ratio indicates a faster collection of receivables, thus more liquidity. Consideration should be given to the days in accounts payable ratio, because higher days in accounts receivable ratio may indicate a drain on cash flow.
Days in Inventory (Inventory × 360) ÷ Cost of Sales Indicates the number of days required to sell inventory. A high ratio may indicate overstocking of inventory.
Days in Accounts Payable (Accounts PayableRetainage) × 360 ÷ Total Cost Indicates the average number of days it takes to liquidate trade payables. The ratio should be compared with credit terms of vendors. Retainage has been excluded.
Operating Cycle Days in Cash + Days in Accounts Receivable + Days in InventoryDays in Accounts Payable Indicates the length of time it takes for the company to complete a normal operating cycle. A low ratio may indicate a need for more permanent working capital.

LIQUIDITY RATIOS

Ratio Formula What It Means
Current Ratio Current Assets ÷ Current Liabilities Indicates the extent to which current assets are available to satisfy current liabilities. Usually stated in terms of absolute values (i.e., 2.1 to 1.0, or simply 2.1). Generally, a minimum current ratio is 1.0, which indicates that current assets at least equal current liabilities.
Quick Ratio (Cash and Cash Equivalents + Short-Term Investments + Net Receivables) ÷ Current Liabilities Indicates the extent to which the more liquid assets are available to satisfy current liabilities. Usually stated in terms of absolute values, a quick ratio of 1.0 is generally considered a liquid position.
Days of Cash ((Cash and Cash Equivalents) × 360) ÷ Revenue Indicates the number of days' revenue in cash. Generally, a ratio of seven days or more is considered adequate.
Working Capital Turnover Revenue ÷ Working Capital

Working Capital
(Current AssetsCurrent Liabilities)
Indicates the amount of revenue being supported by each $1 of net working capital employed. A ratio exceeding 30 may indicate a need for increased working capital to support future revenue growth.

If you have any questions, contact Brian Summers at bsummers@cfma.org or 609.452.8000, ext. 227.

For technical questions, please contact Matthew Chaffin at mchaffin@industryinsights.com or 614.389.2100, ext. 115.

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