TERM PAPER

OF
Working capital
Topic: - How working capital effects capital
investment decisions, example of companies & analysis
(ABB co & Tata steel).
Submitted to:-

Ms. Neha Tikoo

Submitted by:-

Jasneet kaur

RT1809A07

BBA (5th SEM)

WORKING CAPITAL
Working capital (abbreviated WC) is a financial metric which represents operating liquidity
available to a business, organization, or other entity, including governmental entity. Along with fixed
assets such as plant and equipment, working capital is considered a part of operating capital. Net working
capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is
commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less
than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

Working Capital = Current Assets

Net Working Capital = Current Assets − Current Liabilities
A company can be endowed with assets and profitability but short of liquidity if its assets
cannot readily be converted into cash. Positive working capital is required to ensure that a firm
is able to continue its operations and that it has sufficient funds to satisfy both maturing short-
term debt and upcoming operational expenses. The management of working capital involves
managing inventories, accounts receivable and payable and cash.

CALCULATION

Current assets and current liabilities include three accounts which are of special importance. These
accounts represent the areas of the business where managers have the most direct impact:

 accounts receivable (current asset)

 inventory (current assets), and
 accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim
to current assets and is often secured by long term assets. Common types of short-term debt are bank
loans and lines of credit.

An increase in working capital indicates that the business has either increased current assets (that is has
increased its receivables, or other current assets) or has decreased liabilities, for example has paid off
some short-term creditors.

Implications on M&A: The common commercial definition of working capital for the purpose of a working
capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and
purchase agreement) is equal to:
Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets
and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

WORKING CAPITAL MANAGEMENT

Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and its short-
term liabilities. The goal of working capital management is to ensure that the firm is able to continue its
operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses.

Decision criteria
By definition, working capital management entails short term decisions - generally, relating to the next
one year periods - which are "reversible". These decisions are therefore not taken on the same basis as
Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or
profitability.

 One measure of cash flow is provided by the cash conversion cycle - the net number of days
from the outlay of cash for raw material to receiving payment from the customer. As a management
tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts
receivable and payable, and cash. Because this number effectively corresponds to the time that the
firm's cash is tied up in operations and unavailable for other activities, management generally aims at
a low net count.

 In this context, the most useful measure of profitability is Return on capital (ROC). The result is
shown as a percentage, determined by dividing relevant income for the 12 months by capital
employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is
enhanced when, and if, the return on capital, which results from working capital management,
exceeds the cost of capital, which results from capital investment decisions as above. ROC
measures are therefore useful as a management tool, in that they link short-term policy with long-
term decision making. See Economic value added (EVA).

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the
management of working capital. These policies aim at managing the current assets (generally cash and
cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns
are acceptable.

 Cash management. Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.
 Inventory management. Identify the level of inventory which allows for uninterrupted production
but reduces the investment in raw materials - and minimizes reordering costs - and hence increases
cash flow. Besides this, the lead times in production should be lowered to reduce Work in Progress
(WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over
production – see Supply chain management; Just In Time (JIT); Economic order
quantity (EOQ); Economic production quantity
 Debtors’ management. Identify the appropriate credit policy, i.e. credit terms which will attract
customers, such that any impact on cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
 Short term financing. Identify the appropriate source of financing, given the cash conversion
cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be
necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

CAPITAL INVESTMENT
The term Capital Investment has two usages in business. Firstly, Capital Investment refers to
money used by a business to purchase fixed assets, such as land, machinery, or buildings.

Secondly, Capital Investment refers to money invested in a business with the understanding that
the money will be used to purchase fixed assets, rather than used to cover the business' day-to-
day operating expenses.

If you are seeking investors for your business, you will most likely find that interested investors
prefer to make a Capital Investment, specifying what the money will be used for.
Also Known As: Venture capital.
Common Misspellings: Capital investment, capitol investment, capital investment.
Examples:
Jenna agreed to make a capital investment in Bupinder's new business, specifying that the money
was to be used to buy the machinery needed to start production.
ABB CO.

ABB is a Swiss-Swedish multinational corporation headquartered in Zürich, Switzerland, operating

mainly in the power and automation technology areas.

ABB is one of the largest engineering companies as well as one of the largest conglomerates in the
world. ABB has operations in around 100 countries, with approximately 117,000 employees, and reported
global revenue of $31.8 billion for 2009.

ABB is traded on the SIX Swiss Exchange in Zürich and the Stockholm Stock Exchange in Sweden since
1999, and the New York Stock Exchange in the United States since 2001.

Profit loss account

Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Income
Operating income 6,257.82 6,867.77 5,948.45 4,291.34 2,976.30
Expenses
Material consumed 4,550.00 4,984.28 1,559.98 1,244.53 892.06
Manufacturing expenses 117.56 129.68 2,807.92 1,963.56 1,287.86
Personnel expenses 389.23 402.96 306.07 241.42 178.38
Selling expenses 111.37 99.69 74.66 63.71 50.42
Administrative expenses 467.92 435.93 391.75 274.71 229.33
Expenses capitalised -1.55 -4.39 - - -
Cost of sales 5,634.53 6,048.15 5,140.37 3,787.93 2,638.05
Operating profit 623.30 819.62 808.08 503.41 338.25
Other recurring income 51.95 45.25 52.91 50.65 30.90
Adjusted PBDIT 675.24 864.88 860.99 554.06 369.15
Financial expenses 44.35 49.38 17.03 10.10 13.40
Depreciation 48.51 36.68 32.41 26.47 23.14
 Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Other write offs - - - - -
Adjusted PBT 582.39 778.82 811.56 517.49 332.61
Tax charges 178.52 285.83 264.79 182.90 120.80
Adjusted PAT 403.87 492.98 546.77 334.59 211.81
Non recurring items -54.99 54.43 -55.10 5.71 6.87
Other non cash adjustments 5.76 - - - -0.28
Reported net profit 354.64 547.41 491.67 340.31 218.39
Earnings before appropriation 410.30 610.21 543.59 375.25 248.61
Equity dividend 42.38 46.62 46.62 42.38 33.91
Preference dividend - - - - -
Dividend tax 7.20 7.92 9.18 5.94 4.76
Retained earnings 360.72 555.66 487.79 326.93 209.95

Balance sheet of ABB ltd. (Rs.crore)

Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Sources of funds
Owner's fund
Equity share capital 42.38 42.38 42.38 42.38 42.38
Share application money - - - - -
Preference share capital - - - - -
Reserves & surplus 2,367.35 2,062.29 1,569.42 1,138.65 846.67
Loan funds
Secured loans - - - - -
Unsecured loans - 0.02 0.57 1.55 2.73
Total 2,409.73 2,104.70 1,612.37 1,182.58 891.78
Uses of funds
Fixed assets
Gross block 879.26 766.48 576.91 514.52 414.16
Less : revaluation reserve 14.00 14.28 14.54 14.81 15.07
Less : accumulated depreciation 206.13 220.65 224.98 207.34 187.50
Net block 659.13 531.56 337.39 292.36 211.59
Capital work-in-progress 116.34 137.51 105.94 24.62 38.42
Investments 16.88 61.12 70.45 77.35 87.15
Net current assets
Current assets, loans & advances 4,811.08 4,745.68 4,136.80 2,813.24 2,007.45
Less : current liabilities & provisions 3,193.70 3,371.18 3,038.22 2,025.00 1,452.83
Total net current assets 1,617.39 1,374.50 1,098.58 788.24 554.62
Miscellaneous expenses not written - - - - -
 Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Total 2,409.73 2,104.70 1,612.37 1,182.58 891.78

Cash flow
Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Profit before tax 527.40 833.24 756.46 523.21 339.48
Net cash flow-operating activity 354.49 19.67 267.57 245.30 77.21
Net cash used in investing activity -98.58 -224.66 -113.89 -59.38 -53.80
Net cash used in fin. activity -80.00 -89.65 -57.26 -40.45 -39.20
Net inc/dec in cash and equivalent 175.91 -294.63 96.42 145.48 -15.79
Cash and equivalent begin of year 348.23 642.86 546.44 400.97 416.75
Cash and equivalent end of year 524.14 348.23 642.86 546.44 400.97

TATA STEEL

Tata Steel (BSE: 500470), formerly known as TISCO and Tata Iron and Steel Company
Limited, is the world's seventh largest steel company, with an annual crude steel capacity of 31
million tones. It is the largest private sector steel company in India in terms of domestic
production. Ranked 258th on Fortune Global 500, it is based in Jamshedpur, Jharkhand, India. It
is part of Tata Group of companies. Tata Steel is also India's second-largest and second-most
profitable company in private sector with consolidated revenues of 132,110 crore (US$ 29.99
billion) and net profit of over 12,350 crore (US$ 2.8 billion) during the year ended March 31,
2008. Tata steel in the 8th most valuable brand according to an annual survey conducted by
Brand Finance and The Economic Times in 2010.

Its main plant is located in Jamshedpur, Jharkhand, with its recent acquisitions; the company has
become a multinational with operations in various countries. The Jamshedpur plant contains the
DCS supplied by Honeywell. The registered office of Tata Steel is in Mumbai. The company
was also recognized as the world's best steel producer by World Steel Dynamics in 2005. The
company is listed on Bombay Stock Exchange and National Stock Exchange of India, and
employs about 82,700 people (as of 2007).

Profit loss account (Rs.crore)

Mar ' Mar ' Mar ' Mar ' Mar '
10 09 08 07 06

Income
24,940. 24,348. 19,654. 17,452. 15,132.
Operating income
65 32 41 66 09

Expenses
8,491.4 8,279.4 6,024.8 5,679.9 4,661.5
Material consumed
2 4 0 5 3

Manufacturing 3,803.3 3,349.9 2,693.7 2,589.2 2,364.4

expenses 3 6 3 4 0

2,361.4 2,305.8 1,589.7 1,454.8 1,351.5

Personnel expenses
8 1 7 3 1

Selling expenses 82.17 61.49 52.53 64.71 80.75

1,622.7 1,518.8 1,224.5

Administrative expenses 986.20 902.30
7 3 4

Expenses capitalized -326.11 -343.65 -175.50 -236.02 -112.62

16,035. 15,171. 11,409. 10,538. 9,247.8

Cost of sales
06 88 87 91 7

Operating profit 8,905.5 9,176.4 8,244.5 6,913.7 5,884.2

 Mar ' Mar ' Mar ' Mar ' Mar '
10 09 08 07 06

9 4 4 5 2

Other recurring income 331.59 305.36 347.28 485.14 256.95

9,237.1 9,481.8 8,591.8 7,398.8 6,141.1

Adjusted PBDIT
8 0 2 9 7

1,848.1 1,489.5
Financial expenses 929.03 251.25 168.44
9 0

1,083.1
Depreciation 973.40 834.61 819.29 775.10
8

Other write offs - - - - -

6,305.8 7,018.9 6,828.1 6,328.3 5,197.6

Adjusted PBT
1 0 8 5 3

2,168.5 2,114.8 2,380.2 2,040.4 1,734.3

Tax charges
0 7 8 7 8

4,137.3 4,904.0 4,447.9 4,287.8 3,463.2

Adjusted PAT
1 3 0 8 5

Non recurring items 909.49 297.71 239.13 -123.02 -4.37

Other non cash

- - - 57.29 47.50
adjustments

5,046.8 5,201.7 4,687.0 4,222.1 3,506.3

Reported net profit
0 4 3 5 8

Earnings before 14,555. 11,589. 9,281.0 7,198.3 5,296.5

appropriation 78 20 1 1 9

1,168.9 1,168.9
Equity dividend 709.77 943.91 719.51
5 3

Preference dividend 45.88 109.45 22.19 - -

Dividend tax 122.80 214.10 202.43 160.42 100.92

13,677. 10,096. 7,887.4 6,093.9 4,476.1

Retained earnings
33 70 6 8 6
 Balance sheet of Tata steel
Mar ' 10 Mar ' 09 Mar ' 08 Mar ' 07 Mar ' 06
Sources of funds
Owner's fund
Equity share capital 887.41 730.79 730.78 580.67 553.67
Share application money - - - 147.06 -
Preference share capital - 5,472.66 5,472.52 - -
Reserves & surplus 36,281.34 23,501.15 21,097.43 13,368.42 9,201.63
Loan funds
Secured loans 2,259.32 3,913.05 3,520.58 3,758.92 2,191.74
Unsecured loans 22,979.88 23,033.13 14,501.11 5,886.41 324.41
Total 62,407.95 56,650.78 45,322.42 23,741.48 12,271.45
Uses of funds
Fixed assets
Gross block 22,306.07 20,057.01 16,479.59 16,029.49 15,407.17
Less : revaluation reserve - - - - -
Less : accumulated depreciation 10,143.63 9,062.47 8,223.48 7,486.37 6,699.85
Net block 12,162.44 10,994.54 8,256.11 8,543.12 8,707.32
Capital work-in-progress 3,843.59 3,487.68 4,367.45 2,497.44 1,157.73
Investments 44,979.67 42,371.78 4,103.19 6,106.18 4,069.96
Net current assets
Current assets, loans & advances 13,425.27 11,591.66 38,196.34 14,671.91 4,997.00
Less : current liabilities & provisions 12,003.02 11,899.95 9,755.78 8,279.70 6,913.83
Total net current assets 1,422.25 -308.29 28,440.56 6,392.21 -1,916.83
Miscellaneous expenses not written - 105.07 155.11 202.53 253.27
Total 62,407.95 56,650.78 45,322.42 23,741.48 12,271.45

Cash flow (Rs.crore)

Mar ' 10 Mar ' 09 Mar ' 08 Mar ' 07 Mar ' 06
Profit before tax 7,214.30 7,315.61 7,066.36 6,261.65 5,239.96
Net cash flow-operating activity 8,369.22 7,397.22 6,254.20 5,118.10 3,631.39
Net cash used in investing activity -5,254.84 -9,428.08 -29,318.58 -5,427.60 -2,464.59
Net cash used in fin. activity -1,473.13 3,156.42 15,848.07 7,702.46 -1,125.13
Net inc/dec in cash and equivalent 1,641.25 1,125.56 -7,216.31 7,392.96 41.67
 Mar ' 10 Mar ' 09 Mar ' 08 Mar ' 07 Mar ' 06
Cash andequivalentt begin of year 1,592.89 465.04 7,681.35 288.39 246.72
Cash and equivalent end of year 3,234.14 1,590.60 465.04 7,681.35 288.39

FORMULAE OF RATIOS
 Current ratio- current assets/ current liabilities

 Liquidity ratio or acid test ratio or Quick ratio- Quick assets or liquid assets /
current liabilities

SOLVENCY RATIOS

 Debt equity ratio- Debt (long term)/ Equity (shareholders fund)

 Total asset or debt ratio- Total assets/long term debts

 Proprietary ratio- Shareholders’ funds or proprietary funds/total assets

ACTIVITY RATIOS OR TURNOVER RATIOS

 Stock (Inventory) turnover ratio- Cost of goods sold/ average stock

 Debtors or receivable turnover ratio- Net credit sales/average accounts

receivables’ {Average accounts receivables = opening debtors + closing
debtors/2}

 Creditors or payables turnover ratio- Net credit Purchases/average payable

 Working capital turnover ratio- cost of goods sold or net sales/ Net working
capital

 Fixed assets turnover ratio- Net sales/ net fixed assets

 Current assets turnover ratio- Net sales / current assets

PROFITABILITY RATIOS

 Gross profit ratio- Gross profit/net sales * 100

 Operating ratio- Cost of goods sold + operating expenses/Net sales *100

  Net profit ratio- Net profit/net sales*100

 Return on investment or Return on capital employed

- Profit before interest, tax & dividend/capital employed*100

 Earnings per share- Net profit after tax – preference dividend/No. of equity
shares

 Dividend per share- Dividend paid to equity shareholders/No. of equity

shares

 Price earnings ratio- Market price per share/ Earning per share.

AFTER CALCULATIONS RATIOS OF BOTH

THE INDUSTRIEES WERE AS FOLLOWS:-

ABB ltd

Ratios (Rs. crore)

 Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Per share ratios
 Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Adjusted EPS (Rs) 19.06 23.26 25.80 78.95 49.98
Adjusted cash EPS (Rs) 21.35 25.00 27.33 85.19 55.44
Reported EPS (Rs) 16.74 25.83 23.20 80.30 51.60
Reported cash EPS (Rs) 19.02 27.56 24.73 86.54 57.06
Dividend per share 2.00 2.20 2.20 10.00 8.00
Operating profit per share (Rs) 29.41 38.68 38.13 118.78 79.81
Book value (excl rev res) per share (Rs) 113.72 99.32 76.06 278.67 209.77
Book value (incl rev res) per share (Rs.) 114.38 99.99 76.75 282.16 213.33
Net operating income per share (Rs) 295.31 324.09 280.71 1,012.55 702.26
Free reserves per share (Rs) 111.31 96.90 73.63 266.46 197.45
Profitability ratios
Operating margin (%) 9.96 11.93 13.58 11.73 11.36
Gross profit margin (%) 9.18 11.40 13.03 11.11 10.58
Net profit margin (%) 5.62 7.91 8.19 7.83 7.27
Adjusted cash margin (%) 7.16 7.66 9.65 8.31 7.81
Adjusted return on net worth (%) 16.76 23.42 33.92 28.33 23.82
Reported return on net worth (%) 14.71 26.00 30.50 28.81 24.59
Return on long term funds (%) 26.00 39.34 51.38 44.61 38.79
Leverage ratios
Long term debt / Equity - - - - -
Total debt/equity - - - - -
Owners fund as % of total source 100.00 99.99 99.96 99.86 99.69
Fixed assets turnover ratio 7.19 9.08 10.63 8.59 7.42
Liquidity ratios
Current ratio 1.51 1.41 1.36 1.39 1.38
Current ratio (inc. st loans) 1.51 1.41 1.36 1.39 1.38
Quick ratio 1.26 1.20 1.19 1.21 1.23
Inventory turnover ratio 8.94 11.47 13.11 13.05 15.99
Payout ratios
Dividend payout ratio (net profit) 13.98 9.96 11.34 14.20 17.67
Dividend payout ratio (cash profit) 12.29 9.33 10.64 13.17 15.98
Earning retention ratio 87.73 88.94 89.80 85.56 81.75
Cash earnings retention ratio 89.04 89.71 90.37 86.62 83.55
Coverage ratios
Adjusted cash flow time total debt - - - - 0.01
Financial charges coverage ratio 15.23 17.51 50.57 54.88 27.55
Fin. charges cov.ratio (post tax) 10.09 12.83 31.78 37.33 19.05
Component ratios
Material cost component (% earnings) 72.70 72.57 27.10 30.23 30.23
Selling cost Component 1.77 1.45 1.25 1.48 1.69
 Dec ' 09 Dec ' 08 Dec ' 07 Dec ' 06 Dec ' 05
Exports as percent of total sales 8.25 7.68 6.30 10.86 8.13
Import comp. in raw mat. consumed 39.45 33.72 38.26 40.50 44.03
Long term assets / total Assets 0.14 0.13 0.10 0.11 0.13
Bonus component in equity capital (%) 44.35 44.35 44.35 44.35 44.35

The above ratios including the different working capital ratios which show the
ratio table of ABB ltd from Dec 2005 to 2009.

TATA STEEL

Ratios (Rs crore)

Mar ' 10 Mar ' 09 Mar ' 08 Mar ' 07 Mar ' 06
Per share ratios
Adjusted EPS (Rs) 46.12 65.63 60.58 73.87 62.57
Adjusted cash EPS (Rs) 58.32 78.95 72.00 87.98 76.58
Reported EPS (Rs) 56.37 69.70 63.85 72.74 63.35
Reported cash EPS (Rs) 68.58 83.02 75.27 86.85 77.36
Dividend per share 8.00 16.00 16.00 15.50 13.00
Operating profit per share (Rs) 100.38 125.60 112.85 119.11 106.31
Book value (excl rev res) per share (Rs) 418.94 330.24 296.65 236.82 171.68
Book value (incl rev res) per share (Rs.) 418.94 330.24 296.65 236.82 171.68
Net operating income per share (Rs) 281.11 333.27 269.02 300.66 273.40
 Mar ' 10 Mar ' 09 Mar ' 08 Mar ' 07 Mar ' 06
Free reserves per share (Rs) 392.98 309.18 275.25 213.24 147.23
Profitability ratios
Operating margin (%) 35.70 37.68 41.94 39.61 38.88
Gross profit margin (%) 31.36 33.69 37.70 34.91 33.76
Net profit margin (%) 19.96 21.09 23.43 23.53 22.78
Adjusted cash margin (%) 20.65 23.83 26.41 28.47 27.54
Adjusted return on net worth (%) 11.00 19.87 20.42 31.19 36.44
Reported return on net worth (%) 13.45 21.10 21.52 30.71 36.90
Return on long term funds (%) 13.06 15.21 17.16 28.11 43.93
Leverage ratios
Long term debt / Equity 0.67 1.31 1.07 0.67 0.25
Total debt/equity 0.67 1.34 1.08 0.69 0.25
Owners fund as % of total source 59.55 42.77 48.16 59.12 79.49
Fixed assets turnover ratio 1.12 1.22 1.20 1.09 0.98
Liquidity ratios
Current ratio 1.12 0.97 3.92 1.77 0.72
Current ratio (inc. st loans) 1.12 0.91 3.81 1.69 0.71
Quick ratio 0.76 0.57 3.52 1.37 0.29
Inventory turnover ratio 10.90 9.36 10.84 10.81 9.89
Payout ratios
Dividend payout ratio (net profit) 16.64 27.15 29.39 26.15 23.39
Dividend payout ratio (cash profit) 13.68 22.80 24.93 21.90 19.16
Earning retention ratio 79.66 71.16 69.02 74.25 76.32
Cash earnings retention ratio 83.92 76.03 73.94 78.38 80.65
Coverage ratios
Adjusted cash flow time total debt 4.83 4.58 3.41 1.89 0.59
Financial charges coverage ratio 5.00 6.37 9.25 29.45 36.46
Fin. charges cov.ratio (post tax) 4.32 5.15 6.94 21.07 26.42
Component ratios
Material cost component (% earnings) 33.50 35.19 30.85 33.01 31.49
Selling cost Component 0.32 0.25 0.26 0.37 0.53
Exports as percent of total sales 8.41 13.85 11.64 12.05 13.94
Import comp. in raw mat. consumed 59.69 68.85 50.51 48.93 40.42
Long term assets / total Assets 0.81 0.83 0.30 0.53 0.73
Bonus component in equity capital (%) 28.50 34.61 34.61 43.56 45.68

The above ratios including the different working capital ratios which show the
ratio table of Tata steel ltd from Mar 2006 to 2010.
 ANALYSIS
Ratio Analysis enables the business owner/manager to spot trends in a business and to compare
its performance and condition with the average performance of similar businesses in the same
industry. To do this compare your ratios with the average of businesses similar to yours and
compare your own ratios for several successive years, watching especially for any unfavourable
trends that may be starting. Ratio analysis may provide the all-important early warning
indications that allow you to solve your business problems before your business is destroyed by
them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its
bills as they come due) and leverage (the extent to which the business is dependent on creditors'
funding). They include the following ratios:

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick
Ratio, and Working Capital.

Current Ratios

The Current Ratio is one of the best known measures of financial strength. It is figured as shown
below:

Current Ratio = Total Current Assets / Total Current Liabilities

The main question this ratio addresses is: "Does your business have enough current assets to
meet the payment schedule of its current debts with a margin of safety for possible losses in
current assets, such as inventory shrinkage or collectable accounts?" A generally acceptable
current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of
the business and the characteristics of its current assets and liabilities. The minimum acceptable
current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.

If you feel your business's current ratio is too low, you may be able to raise it by:

• Paying some debts.

• Increasing your current assets from loans or other borrowings with a maturity of more
than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.
Quick Ratios

The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of
liquidity. It is figured as shown below:

Quick Ratio = Cash + Government Securities + Receivables / Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding
inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps
answer the question: "If all sales revenues should disappear, could my business meet its current
obligations with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in
accounts receivable, and the pattern of accounts receivable collection lags behind the schedule
for paying current liabilities.

Working Capital

Working Capital is more a measure of cash flow than a ratio. The result of this calculation must
be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to weather
financial crises. Loans are often tied to minimum working capital requirements.

A general observation about these three Liquidity Ratios is that the higher they are the better,
especially if you are relying to any significant extent on creditor money to finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt
financing (creditor money versus owner's equity):

Debt/Worth Ratio = Total Liabilities / Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your
business, making it correspondingly harder to obtain credit.

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net
sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the
goods sold) available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal the relative
strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows:

Gross Margin Ratio = Gross Profit / Net Sales

Reminder: Gross Profit = Net Sales - Cost of Goods Sold

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all
expenses, except income taxes. It provides a good opportunity to compare your company's
"return on sales" with the performance of other companies in your industry. It is calculated
before income tax because tax rates and tax liabilities vary from company to company for a wide
variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin
Ratio is calculated as follows:

Net Profit Margin Ratio = Net Profit Before Tax / Net Sales

Management Ratios

Other important ratios, often referred to as Management Ratios, are also derived from Balance
Sheet and Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the more times
inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover
Ratio is calculated as follows:

Inventory Turnover Ratio = Net Sales / Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If receivables are not
collected reasonably in accordance with their terms, management should rethink its collection
policy. If receivables are excessively slow in being converted to cash, liquidity could be severely
impaired. Getting the Accounts Receivable Turnover Ratio is a two step process and is
calculated as follows:
 Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)

Accounts Receivable Turnover (in days) = Accounts Receivable / Daily Credit Sales

Return on Assets Ratio

This measures how efficiently profits are being generated from the assets employed in the
business when compared with the ratios of firms in a similar business. A low ratio in comparison
with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio
is calculated as follows:

Return on Assets = Net Profit Before Tax / Total Assets

Return on Investment (ROI) Ratio

The ROI is perhaps the most important ratio of all. It is the percentage of return on funds
invested in the business by its owners. In short, this ratio tells the owner whether or not all the
effort put into the business has been worthwhile. If the ROI is less than the rate of return on an
alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell
the company, put the money in such a savings instrument, and avoid the daily struggles of small
business management. The ROI is calculated as follows:

Return on Investment = Net Profit before Tax / Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to
identify trends in a business and to compare its progress with the performance of others through
data published by various sources. The owner may thus determine the business's relative
strengths and weaknesses.