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Ratio Analysis

Cash Flow Statement

Ratio analysis helps us interpret and evaluate the information contained in financial and other statements. We analyze your financial statements and your cash flow statement to achieve the following goals:

* Evaluate management's performance in earning a rate of return.

* Appraise the firm's financial soundness.

* Help make predictions about the firm's future financial performance.

Ratio analysis is the process of calculating and interpreting financial ratios. A ratio is an index which relates numbers as is derived by dividing one quantity by another.

For example, suppose a business on a certain date has current assets of $50,000 and current liabilities of $25,000. A commonly employed measure is the Current Ratio which is computed by dividing current assets by current liabilities.

                    Current Ratio =   Current Assets   = 50,000 = 2 to 1
                                            Current Liabilities    25,000


The 2 to 1 ration means that at that date the business had $2 of current assets for each $1 of current liabilities.

Ratios are used in analyzing your financial statements and your cash flow statement because they reduce the data to a workable form, thus making the information more meaningful.

Each financial ratio can be compared to a "range" of values from the Industry Standard. The "range" consists of all the financial ratio values from all companies utilized in creating the Industry Standard.

Ratios are interrelated. The fact may be evaluated in terms two fundamental precepts; make money and stay solvent. They have a kinship with three commandments of sound financial management; don't overbuy, don't over trade and don't over expand.

Ratios Classification

Ratios are classified into four different categories; Liquidity, Coverage Ratios, Leverage Ratios and Operating Ratios.

1. Liquidity Ratios

Ratios in this category are designed to assist one in judging if a business can pay its current liabilities when due. Liquidity ratios include the Current Ratio, Quick Ratio, Sales to Receivable Ratio, Cost of Sales to Inventory Ratio, Cost of Sales to Payables Ratio and the Sales to Working Capital Ratio.

2. Coverage Ratios

Coverage ratios measure business' ability to service debt. They include the Debt to Interest Ratio and the Cash Flow to current Maturity Ratio.

3. Leverage Ratios

Leverage ratios provide insight into the extent to which a business is relying on debt financing. Thus, they measure the vulnerability of a firm to business downturns due to its debt. Leverage ratios include the Fixed to Worth Ratio and the Debt to Worth Ratio.

Leverage ratios measure the financial risk of a business due to debt capital rather than equity capital. Highly leveraged firms (those with heavy debt in relation to net worth) are more vulnerable to business downturns. The greater the amount of debt, the smaller the cushion for a mistake. If a business earns a return on invested capital greater than the cost of obtaining and repaying debt, the business captures the spread. This is referred to as "favorable trading equity." A business is considered highly leveraged when total debt represents more than 200 to 250% of net worth. A firm is also considered highly leveraged when long term debt is more than net worth because lenders have more capital in the business than do owners.

4. Operating Ratios

Operating ratios serve very useful purposes. They enable managers to allocate, budget and plan. Successful business management makes use of them to begin each year by designating the percentage of each sales dollar that will go toward salaries, rent, travel, general administration and so forth. With such management by forecast, a business owner can control progress and, if things go wrong, make immediate adjustments. It is a means of forcing profitability.

Secondly, by comparing Percentage to Sales Ratios derived by administering costs within a business with those compiled from the Industry Standard, one can get a good idea if operating costs are in balance. If they are not, immediate corrective action can be taken.

The operating ratios that Rizzolo Group uses include the Percentage of Profit Before Taxes to Net Worth Ratio, Percentage of Profit Before Taxes to Total Assets Ratio and the Sales to Net Fixed Assets Ratio.


 

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