Tools for Surviving a Downturn:
Simple Financial Ratios to Check Your Business’ Vital Signs
By Greg Gould, Center Director and Certified Business Counselor
at the Maine SBDC Service Center at Androscoggin Valley Council of Governments(AVCOG) in Auburn
Below are some fairly simple ratios that you can use to periodically check your business’s
Liquidity ratios measure a firm’s ability to meet is current financial obligations. You will need
your Balance Sheet to perform these calculations.
Current Assets are the assets that are the most “liquid”, and can be used to pay bills in the near
future. They include:
• Accounts Receivable
• Marketable Securities
Current Liabilities are the bills that are due in the near future. They include:
• Accounts Payable
• Accrued Income Taxes
• Short Term Notes Payable
• Other Accrued Expenses (usually
• Current Portion of Long Tern Deb
wages and taxes)
(that which is due within one year)
CURRENT RATIO =
If your current ratio is greater than 1.0, you have at least enough cash, or assets that can quickly be
converted to cash, to pay your bills. However, if your current ratio is less than 1.0, you have more
bills than money. Let’s take a look at the following example.
Current Assets =
Current Liabilities = $40,000
CURRENT RATIO = .5
Put simply, this means you have twice as many bills as you have money to pay them!
Current Assets - Inventory
QUICK RATIO (ACID TEST) =
Many financial analysts prefer the quick ratio (sometimes called the acid test) as a better means to
determine a firm’s liquidity. The quick ratio subtracts inventory from current assets, as inventory
is almost always the least “liquid” current asset. Inventory represents the asset where losses are
most likely to occur in the event of liquidation. In many cases, the most desirable inventory items
have already been sold, leaving only slow selling or discontinued items that have been in stock for
a long time. Therefore, they may have less worth and cannot be converted to cash easily.
As in the case of the current ratio, the quick ratio needs to be greater than 1 in order for the firm to
be deemed solvent. Most healthy companies have a current ratio of at least 3. As healthy
companies typically turn inventory quickly, and carry as little inventory as necessary, the
corresponding quick ratio will hopefully be greater than 2.5. Of course, these numbers vary by
When a business gets into financial difficulty, it begins to pay its bills more slowly, dips into its
line of credit, etc. If current liabilities rise faster than current assets, the current ratio will fall, and
this could serve as a significant warning sign. Can the business meet its obligations? Will it have
the resources to replenish inventory? What strategies can be implemented to increase current
assets before the business runs out of resources to implement any new strategies?
ASSET MANAGEMENT RATIOS
Asset management ratios measure how effectively a business is managing its assets. You will
need your Balance Sheet to find the inventory and receivables levels, as well as your Income
Statement (also called a Profit and Loss) for the sales information.
INVENTORY TURNOVER RATIO =
The inventory turnover ratio approximates how many times a business sells out and restocks its
inventory during the course of the year. If sales show signs of weakening, the ratio will go down.
While this is a good ratio to monitor, it does have some potential inaccuracies built in.
First, sales are stated at market price; inventories are stated at cost. Therefore, if sale prices drop,
the ratio might be understated. Let’s take a look at the following example:
INVENTORY TURNOVER RATIO = 3
Now, what if we had to reduce the sale price to move the same level of inventory?
INVENTORY TURNOVER RATIO = 2.5
Second, sales occur over the entire year, while the inventory figure is generally for one point in
time. Therefore, some prefer to use an average inventory measure. If a business is seasonal, or
there has been a strong upwards or downwards tick in sales, the ratio will be affected.
If you would like to calculate an average inventory figure, sum up the monthly inventory
figures and divide by 12, or add the beginning and ending inventory figures and divide by 2
(beginning and ending inventory can also be found on your tax return).
If sales slow down or inventories rise (or both), the inventory turnover ratio will decrease. This
sends up a potential red flag. Having an idea of what your inventory turnover ratio is during good
times will help you pick up on economic slowdowns more quickly, so you can make adjustments
DAYS SALES OUTSTANDING =
Days Sales Outstanding (DSO) is also called the average collection period. It measures the
number of days that sales are tied up in receivables. In other words, it shows how long after the
sale a business has to wait before it receives the actual cash. This is a very important tool! Money
tied up in receivables is money that cannot immediately be used to pay bills or replenish inventory.
While many firms extend credit in order to maintain good customers and remain competitive, they
need to understand that reserve funds are necessary. These funds can come in the form of cash
savings or a business line of credit.
Offering small discounts (2%) for payment within 10 days is a commonly used tool to entice
customers to pay quickly. Would you rather give up 2% of the sale price or spend a much higher
percentage in interest (usually 8% or 9%) by using your line of credit?
DEBT MANAGEMENT RATIOS
Debt management ratios measure an organizations degree of debt, or “leverage”. These ratios can
then be used to analyze the risk/return relationship each business faces. You will need your
Balance Sheet and your Income Statement to perform these calculations.
• Total Debt and Total Assets can be found on the Balance Sheet
• Earnings before Interest and Taxes (EBIT) and Interest Charges can be found on
DEBT RATIO =
Quite simply, the debt ratio measures the percentage of financing supplied by creditors. For
example, a debt ratio of 58.7% means that banks (or other creditors) have contributed almost 60%
of the firm’s financing. The higher the debt ratio, the less inclined a bank will be to consider
lending more money, and the higher the potential risk of insolvency. Compare your debt ratio to
the average in your particular industry.
If you are a business in distress with a high debt ratio, you may consider seeking restructuring your
existing debt to lower your payments as opposed to securing new debt.
Interest and Taxes (EBIT)
TIMES INTEREST EARNED RATIO =
Times Interest Earned (TIE) measures how far income can fall before an organization can no
longer meet its interest costs. While this calculation is generally performed with annual numbers,
it can just as easily be calculated with monthly figures.
If a firm’s TIE is 4.5, then the firm generates $4.50 in operating income per dollar of interest
expense. Because more debt will raise the denominator in the calculation (thus lowering the ratio),
a bank is much more likely to approve new debt IF the new debt will generate enough income to
increase the ratio.
While the previous three sets of ratios offer information regarding how a business is operating,
profitability ratios show the combined effects of liquidity, asset management, and debt
management on operating results.
PROFIT MARGIN ON SALES =
Profit Margin on Sales measures the profit per dollar of sales. For example, a profit margin on
sales level of 4% means that for every $1 of revenue, $0.04 remains as profit after all the expenses
and taxes are paid.
This DOES NOT mean that the owner will have $0.04 to put in his or her pocket for each dollar of
sales. Net Income is reported on the Income Statement, whose purpose is to determine the taxable
obligation of a business. Hence, tax deductible expenses are reported.
• As the principal portion of debt is not tax deductible, it is not included on the
Income Statement. The Statement of Cash Flow will include both interest and
• Depreciation is a non-cash charge. It represents the assets being written down over
the course of their useful lives. The IRS allows depreciation to be recorded as an
expense, thus lowering the taxable obligation.
Net Income Available
To Stockholders (Owners)
RETURN ON TOTAL ASSETS (ROA) =
Return on Assets measures an organization’s earning power derived from assets. Large
corporations will have a Net Income Available to Stock holders. you can use Net Income on your
Income Statement. Here is some food for thought…
QUESTION: Why is a highly leveraged firm (a firm with a lot of debt) likely to have a lower ratio
than a similar company with less debt and more equity?
ANSWER: At first glance of the formula, you might think that the proceeds of a loan are used to
purchase assets, thus raising both the numerator (Interest Expense) and the denominator. While
this is correct, debt is not always used to purchase assets. Moreover, not all assets will generate
income. For example, purchasing a building for $200,000 might facilitate a boost in sales, but will
it be a large enough boost to increase the ratio?