Module 3 "Ratio Analysis"

This page is from Module 4: Other Reporting and Ethics

in the course Club Finances for Bookkeepers and Junior Accountants.

Ratios Defined

Looking at raw numbers alone does not always provide all the information about a financial operation. While a ratio is simply one number divided by another mathematically, ratios are a valuable analytical tool for evaluating the club's overall financial condition.

Various categories of ratios shed light on different aspects of a business, such as liquidity, profitability, operational efficiency, and debt obligations. Regular analysis of key ratios over time allows trends and changes to be spotted that the numbers may not necessarily reveal.

The primary ratio categories are liquidity, solvency, activity, profitability, and operating. Use the tabs below to learn more about the various ratio categories.

Click each item below to learn more.

Liquidity Ratios
Solvency Ratios
Activity Ratios
Profitability Ratios
Operating Ratios

These ratios measure a firm's ability to pay short-term debt obligations. Examples of these ratios are:

$LaTeX: Current \space Ratio = Current \space Assets \space / \space Current \space Liabilities$

$LaTeX: Quick \space Ratio = (Cash\space+\space Short \space Term\space Investments \space + \space Account \space Receivables) \space / \space Current \space Liabilities$

$LaTeX: Cash \space Ratio \space = \space Cash \space / \space Current \space Liabilities$

These ratios measure a firm's ability to meet long-term debt obligations. Examples of these ratios are:

$LaTeX: Debt \space Ratio \space = \space Total \space Liabilities \space / \space Total \space Assets$

$LaTeX: Times \space Interest \space Earned \space = \space Earning \space Before \space Interest \space and \space Taxes \space / \space Interest \space Expense$

These ratios measure how efficiently a company utilizes its assets and resources. Examples of these ratios are:

$LaTeX: Inventory \space Turnover \space = \space Cost \space of \space Goods \space Sold \space / \space Average \space Inventory$

Note: Average Inventory is calculated by taking:

$LaTeX: (Beginning \space Inventory \space + \space Ending \space Inventory)/2$

$LaTeX: Average \space Collection \space Period \space = \space Accounts \space Receivable \space / \space (Net \space Credit \space Sales \space / \space 365)$

These ratios measure how effectively a company generates profits relative to sales, assets, and equity. Examples of these ratios are:

$LaTeX: Return \space on \space Assets \space = \space Net \space Income \space / \space Total \space Assets$

$LaTeX: Return \space on \space Equity \space = \space Net \space Income \space / \space Shareholder's \space Equity$

$LaTeX: Net \space Profit \space Margin \space = \space Net \space Income \space / \space Net \space Sales$

These ratios analyze specific components of operations like labor, food costs, etc. Examples that could be used in a restaurant include:

$LaTeX: Food \space Cost \space Percentage \space = \space Food \space Costs \space / \space Food \space Sales$

$LaTeX: Beverage \space Cost \space Percentage \space = \space Beverage \space Costs \space / \space Beverage \space Sales$

Overall ratio analysis transforms basic accounting figures into valuable performance indicators. They also serve as a diagnostic tool to evaluate strengths/weaknesses and monitor progress toward goals. Therefore, regular calculation and interpretation of key ratios are essential to understanding an organization's fiscal position.

Why Use Ratios

Managers use ratios to monitor operating performance and evaluate their success in meeting goals. Creditors use ratios to evaluate a business's solvency and assess the risk of extending credit. Investors in a company, like a club, which would be potential members, use ratios to evaluate a business's performance and ability to meet the investors' specific goals.

Different ratios communicate different results. Ratios reveal important information that may not be obvious or apparent in the financial statements. Rather than evaluating a ratio for a single period, consider the same ratio over a time period.

The proper way to express a ratio depends on the relationship between the two facts it relates to. Different ratios are read in different ways, such as:

percentages (food cost)
per unit basis (average check)
turnover (seat turnover in restaurants)
coverage (current ratio)

Ratios do not provide answers in and of themselves and are not predictive. They should be used with other elements of financial analysis. They are best used when compared to a standard based on historical costs. There are no “rules of thumb” that apply to the interpretation of ratios. Making these various comparisons transforms ratios from simple numbers into actionable metrics that can guide strategic business decisions and maximize profits over the long run.