N.M. Admin. Code § 2.60.27.13

Current through Register Vol. 36, No. 1, January 14, 2025

Section 2.60.27.13 - RATIO ANALYSIS

Ratios are mainly indicators and as such should not be accepted nor used as absolute measurements. They are useful in pointing up areas of strength and weakness in statements. Many ratios are purely quantitative by nature and should not in any way be interpreted as measures of quality. A series of ratios over several periods of time is useful in pointing out trends in financing and operations. Ratios computed for any given company should be compared to industry ratios. If available, all significant variations should be investigated and explained. The following are basic ratios:

A. QUICK RATIO:

(1) Method of computation: The total of cash, short-term marketable securities and net receivables for the company is divided by the total of current liabilities.

(2) Result: The ratio measures short-term liquidity available to meet current debt.

(3) Principle: Also known as the acid test or liquidity ratio, it is of particular benefit to short-term creditors, as it expresses the extent to which cash and those assets most readily convertible into cash can meet the demands of current liabilities. Any value of less than 1 to 1 implies a reciprocal "dependency" on inventory or other current assets to liquidate short term debts.

B. CURRENT RATIO:

(1) Method of computation: The total of current assets for the company is divided by the total of current liabilities.

(2) Result: The ratio is one measure of the ability of the company to meet its current debt.

(3) Principle: In comparing an individual company to the industry, a higher current ratio indicates that more current assets are free from debt claims of creditors and prompter payment can be expected.

C. FIXED/WORTH:

(1) Method of computation: The net fixed assets (plant and equipment less reserve for depreciation) for the company is divided by the tangible net worth.

(2) Result: The ratio expresses the proportion between investment in capital (fixed) assets and the owner's capital.

(3) Principle: The higher the ratio, the less owner's capital is available for working capital. The lower this ratio, the more liquid is the net worth and the more effective the owner's capital is as a liquidating protection to creditors. The presence of substantial leased fixed-assets, off the balance sheet, may deceptively lower the ratio.

D. DEBT/WORTH:

(1) Method of computation: The total debt for the company is divided by the tangible net worth.

(2) Result: The ratio expresses the relationship between capital contributed by creditors to owner's capital-- "what is owed to what is owned".

(3) Principle: Total assets or resources represent the entire capital at the disposal of a company and consist of net worth or owner's capital, and creditor capital, that provided by those outside the business for temporary use. The proportion existing between debt and worth, or leverage, records the debt pressure. The lower the ratio, the easier the pressure and the greater the protection for creditors.

E. PROFITS BEFORE TAXES/WORTH:

(1) Method of computation: The amount of net profit before taxes is divided by the tangible net worth (previous year end).

(2) Result: The ratio expresses the relationship between the owner's share of operations before taxes for the year and the capital already contributed by the owners.

(3) Principle: Capital is usually invested in a company in the anticipation of a return on that investment in the form of a profit. This hope of a profit is the attraction for original and new capital. The higher the profit before taxes to worth, the greater is the probability of making appreciable addition to owners' capital after payment of dividends and taxes.

F. PROFITS BEFORE TAXES/TOTAL ASSETS:

(1) Methods of computation: The net profit before taxes of the company are divided by the total assets for the company.

(2) Result: The ratio expresses the owners' share of the year's operations before taxes related to the resources contributed by both owners and creditors.

(3) Principle: The relationship indicates the net profitability of the use of all resources of the business.

G. CASH PROFIT/CURRENT MATURITIES LONG TERM DEBT:

(1) Method of computation: The net profits plus depreciation and amortization are divided by the current portion of long term liabilities.

(2) Result: The ratio expresses the ability to retire term debt each year from cash generated by operations.

(3) Principle: Cash profit or "throw-off" is the primary source of regular repayment of long term debt. This ratio measures the coverage of such debt service. Often most if not all of the depreciation will be needed for fixed asset replacements and expenditures and similarly part of net profits may be committed to dividends. Hopefully, after all these payments, some portion of cash profit will be left available to enhance working capital. Although all cash profit is not available for debt service, the ratio is a valid measure of the optimum coverage and a useful calculation in all considerations of term lending.

H. UNSUBORDINATED DEBT/CAPITAL FUNDS:

(1) Method of computation: Total unsubordinated debt (all current plus senior long term debt) is divided by capital funds (tangible net worth plus long term subordinated debt).

(2) Result: The ratio expresses the proportion between senior creditors' capital and that provided by junior creditors and owners.

(3) Principle: The ratio records debt leverage in relation to the capital base, sometimes referred to as the borrowing base. This gives recognition in the borrowing base to that capital provided by creditors whose rights are subordinated to other creditors. The use of subordinated debt capital does not altogether remove a corresponding amount of debt pressure from owner's capital, but it does provide an extra cushion for senior creditors who can then view leverage from this ratio.

I. SALES/RECEIVABLES:

(1) Method of computation: The net annual sales for the company are divided by the total of trade accounts and bills receivables.

(2) Results: The ratio expresses the relationship of the volume of business to the outstanding receivables.

(3) Principle: A higher ratio, a higher turnover of receivables indicates a more rapid collection of sales during the period and a greater liquidity of the receivables.

J. DAY'S SALES:

(1) Method of computation: The sales/receivables is divided into 360 (the number of days in one year).

(2) Result: This figure expresses the average time in days that sales are uncollected.

(3) Principle: A comparison of this figure with the terms of sale for the industry will show the extent of control over credit and collections. The greater the number of days outstanding, the greater is the probability of delinquencies in accounts receivable.

K. COST OF SALES/INVENTORY:

(1) Method of computation: Cost of sales for the company is divided by the total of inventory.

(2) Result: The ratios expresses the proportion between cost of sales and inventory at the end of the fiscal period.

(3) Principle: The physical turnover measures merchandising capacity. The higher the ratio the greater is this capacity and the more probable the freshness, salability, and liquidating value of that inventory. Since profit has been eliminated, the cost of sales/inventory gives a more accurate measure of physical turnover than the sales/inventory. Other measures of physical turnover use average monthly inventory or an average of the inventories at the beginning and end of the period.

L. SALES/WORKING CAPITAL:

(1) Method of computation: The net annual sales for the company is divided by the net working capital or excess of total current assets over current liabilities.

(2) Result: The ratio expresses the turnover or annual activity of that portion of net capital not devoted to fixed or other non-current assets.

(3) Principle: Net working capital represents the basic support for those assets undergoing conversion cycles (as inventory-receivables-cash) during the selling year. Relating sales to working capital suggests the number of turns in working capital per annum. A low ratio may indicate unprofitable use of working capital while a very high ratio of ten signifies overtrading, a vulnerable condition for creditors.

M. SALES/NET WORTH:

(1) Method of computation: The net annual sales are divided by the tangible net worth.

(2) Result: The ratio reflects the activity of owners' capital during the year.

(3) Principle: Capital is invested in an enterprise in the hope of a substantial return. The probability of such a return is largely dependent upon a reasonable activity of the investment. This ratio is one measure of this activity. When the relation increases from year to year, it indicates that owner's capital is being used more frequently during the year. A very high ratio may indicate under capitalization (lack of sufficient ownership capital) or overtrading.

N.M. Admin. Code § 2.60.27.13

Recompiled 10/01/01