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Lecture 3

ADMS 4540 Lecture 3: Financial Ratio meaning

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Administrative Studies
ADMS 4540
William Lim

Financial Ratio meaning: Percentage increase (decrease) in sales between two time periods. Sales Growth = Current Period –Previous Period Sales If overall costs and inflation are increasing, then you should see a corresponding Previous Period Sales increase in sales. If not, then may need to adjust pricing policy to keep up with costs. Measures the composition of an organization’s revenue sources (examples are sales, contributions, grants). The nature and risk of each revenue source should be analyzed. Is it recurring, is Reliance on Revenue Source = your market share growing, is there a long term relationship or contract, is there Revenue Source Total a risk that certain grants or contracts will not be renewed, is there adequate RevenueTotal Revenue diversity of revenue sources? Organizations can use this indicator to determine long and short-term trends in line with strategic funding goals (for example, move towards self-sufficiency and decreasing reliance on external funding). Measures the degree to which the organization’s expenses are covered by its core business and is able to function independent of grant support. Operating Self-Sufficiency = For the purpose of this calculation, business revenue should exclude any non- Business Revenue operating revenues or contributions. Total expenses should include all expenses Total Expenses (operating and non-operating) including social costs. A ratio of 1 means you do not depend on grant revenue or other funding. How much profit is earned on your products without considering indirect costs. Gross Profit Margin = Gross Profit Total Sales Is your gross profit margin improving? Small changes in gross margin can Total Sales significantly affect profitability. Is there enough gross profit to cover your indirect costs. Is there a positive gross margin on all products? Net Profit Margin = How much money are you making per every $ of sales. This ratio measures your Net Profit ability to cover all operating costs including indirect costs Sales SGA to Sales = Percentage of indirect costs to sales. Indirect Costs (sales, general, admin) Sales Look for a steady or decreasing ratio which means you are controlling overhead Return on Assets = Measures your ability to turn assets into profit. This is a very useful measure of Net Income comparison within an industry. Total Assets A low ratio compared to industry may mean that your competitors have found a way to operate more efficiently. After tax interest expense can be added back to numerator since ROA measures profitability on all assets whether or not they are financed by equity or debt Rate of return on investment by shareholders. Return on Equity = This is one of the most important ratios to investors. Are you making enough Net Profit Shareholder Equity profit to compensate for the risk of being in business? How does this return compare to less risky investments like bonds? OperationalEfficiencyRatios How efficiently are you utilizing your assets and managing your liabilities? These ratios are used to compare performance over multiple periods. Ratio What does it tell you? Compares expenses to revenue. Operating Expense Ratio = Operating Expenses A decreasing ratio is considered desirable since it generally indicates increased Total Revenue efficiency. Accounts Receivable Turnover = Number of times trade receivables turnover during the year. Net Sales The higher the turnover, the shorter the time between sales and collecting cash. Average Accounts Receivable What are your customer payment habits compared to your payment terms. You may need Days in Accounts Receivable = Average Accounts to step up your collection practices or tighten your credit policies. These ratios are only useful if majority of sales are credit (not cash) sales. Receivable Sales x 365 Inventory Turnover = The number of times you turn inventory over into sales during the year or how many Cost of Sales days it takes to sell inventory. Average Inventory This is a good indication of production and purchasing efficiency. A high ratio indicates Days in Inventory = inventory is selling quickly and that
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