Part 3 of 3
Total Debt To Net Worth: Total Liabilities ÷ Net Worth
This ratio expresses the relationship between capital contributed by creditors and that contributed by owners. It expresses the degree of protection provided by the stockholders for the creditors.
The higher the ratio, the greater the risk of being assumed by creditors. A lower ratio generally indicates greater long-term financial safety.
The effect of long-term (funded) debt on a business can be determined by comparing this ratio with the Current Liabilities to Net Worth Ratio. The difference will pinpoint the relative size of long-term debt, which can burden a firm with substantial interest charges.
Total liabilities shouldn’t exceed net worth (100 percent) since in such cases creditors have more at stake than stockholders.
Operating Ratios
Operating ratios are used to assist in the evaluation of management performance. These consist of the following key ratios:
Percent Profits Before Taxes ÷ Tangible Net Worth
This ratio expresses the rate of return on tangible capital employed. While it can serve as an indicator of management performance, it should be used together with other ratios.
A high return, normally associated with effective management, could suggest an undercapitalized firm. Conversely, a low return, usually an indicator of inefficient management performance, could reflect a highly capitalized, conservatively operated business. Profits before taxes may be zero, in which case the ratio is zero.
% Profit Before Taxes ÷ Total Assets
This ratio expresses the pretax return on total assets and measures the effectiveness of management in employing the resources available to it. It is also called the rate of return on investment, and it shows how efficiently a firm manages resources.
It is different from the Return On Equity more money is available for dividends and/or reinvestment in the firm. This ratio can be used to compare the performance of the investment in a company compared with other investment opportunities.
If this ratio varies considerably from the industry average, a detailed examination of the composition of the assets and a closer look at the earnings figure is warranted.
A heavily depreciated facility and a large number of intangible assets or unusual income or expense will cause distortions of this ratio.
Total Assets Turnover: Net Sales ÷ Total Assets
This ratio is used to measure the sales generated by each dollar of assets. High asset turnover is preferred. A low turnover could mean that the firm requires more assets than a firm with a high asset turnover or that the firm is not using its assets in an efficient manner.
If the ratio is less than the Industry Average, this means the company is simply not generating a sufficient volume of business for the size of the asset investment.
Sales should be increased, or some assets should be disposed of, or both steps should be taken.
Conclusion
These are the key ratios that a small business or any business, for that matter, should keep a close track of and fully understand the implications.
It is important to compare yourself to your industry. It is even more important to monitor your own progress. Improvements in indicators – even an improvement of a tenth of a percent will show management what strategies are working and how to capitalize on their strengths and minimize their weaknesses.
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