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 Margin Ratio = _______________
(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 = _____________________
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:
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
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 = ________________________
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 = ____________________
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.