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Sunday, October 24, 2010

Financial Metrics - Income Ratios

Successful businesses constantly evaluate the performance of the company.  As Jack Welch states, “If change is happening on the outside faster than on the inside the end is in sight.”  The trend and ratio analysis of income is a critical component to strategic planning.  Income Ratios measure the sales with operating assets, investment in a business is adequate, company policy and the business climate, and profitability of sales.  The following are income ratios:
  • Turnover of Total Operating Assets
  • Net Sales to Tangible Net Worth
  • Gross Margin on Net Sales
  • Operating Income to Net Sales Ratio


Turnover of Total Operating Assets - an increase in sales will necessitate more operating assets at some point, conversely, an inadequate sales volume may call for reduced investment.  Turnover of Total Operating Assets tracks over-investment in operating assets.

     Net Sales / Total Operating Assets* = Turnover of Total Operating Assets Ratio

     *  Total operating assets = total assets - (long term investments + intangible assets)

Remember, over-investment may result in a lack of adequate profits.

Net Sales to Tangible Net Worth - the ratio indicates whether your investment in the business is adequately proportionate to your sales volume.  It may also uncover potential credit or management problems.  Problems are typically called over and under trading.  Over trading is thin margins on high volume and can come from considerable management skill, while outside creditors must furnish more funds to carry out daily operations.  Under trading is usually caused by management's poor use of investment money and lack of skill and aggressiveness.

     Net Sales / Tangible Net Worth* = Net Sales to Tangible Net Worth Ratio

     *  Tangible Net Worth = Owner's Equity - Intangible Assets

Gross Margin on Net Sales - by analyzing changes in this figure over several years, you can identify whether it is necessary to examine company policies relating to credit extension, markups (or markdowns), purchasing, or general merchandising.  An increase in gross margin may result from higher sales, lower cost of goods sold, an increase in the proportionate volume of higher margin products, or any combination of these variables.

     Gross Margin* / Net Sales = Gross Margin on Net Sales Ratio

     *  Gross Margin = Net Sales - Cost of Goods Sold

Operating Income to Net Sales Ratio - the ratio reveals the profitability of sales resulting from regular business as well as buying, selling, and manufacturing operations.  Operating income derives from ordinary business operations and excludes other revenue (losses), extraordinary items, interest on long-term obligations, and income taxes.

     Operating Income / Net Sales = Operating Income to Net Sales Ratio


Income ratios are a key component of a consistent review and understanding the pulse/direction of the business.  Read more about ratios at:  Financial Metrics - Ratio Analysis Considerations