Understanding This Powerful Tool for Managing for Success
by Kristi Reale, CPA, CVA, published on 03/14/2011 in Business West
Performance management is an important component of running a business, and there are many tools available to help a company identify, measure, and manage its performance. The use of financial ratios is a time-tested, quantitative method of analyzing a company’s financial statements and provides a detailed, clear picture of the company’s financial performance.
Financial ratios are also utilized by bankers and other lenders to learn about a company’s health and determine its credit worthiness. This article will provide an overview of the standard financial ratios most often used by business owners, management teams and lenders.
The four basic categories of financial ratios discussed below are liquidity ratios, efficiency ratios, leverage ratios, and profitability ratios. Within these categories, here are the most common measures used.
Based on balance-sheet line items, liquidity ratios measure your company’s ability to meet its near-term obligations, or how much cash the business has on hand for immediate use. These are among the first ratios that are used by lenders when considering a company’s loan request.
Current Ratio: Current assets divided by current liabilities — the extent over which current assets cover current liabilities and a snapshot of the ability to generate sufficient cash to cover short-term liabilities. In theory, the higher the current ratio, the better.
Quick Ratio: Cash and cash equivalents plus net receivables divided by current liabilities — a conservative creditor’s view because it excludes the least-liquid current assets (inventory and prepaids). A higher ratio means a more liquid current position.
Working Capital: Current assets minus current liabilities — this measurement provides an indication of the company’s ability to generate resources.
Efficiency ratios come from line items on both the balance sheet and profit-and-loss statement and are typically used to analyze how effectively a company is turning over its accounts receivable, or inventory, and thus able to meet both its short-term and long-term obligations. These ratios are key indicators of how well a company uses its assets and manages its liabilities.
Accounts-receivable Turnover: Net revenue divided by average accounts receivable and days’ sales in accounts receivable: 365 divided by accounts-receivable turnover — the number of times receivables turn into cash in a year (turnover) and the average length of time from a sale to cash collection.
Inventory Turnover: Cost of goods sold divided by average inventory and days’ sales in inventory: 365 divided by inventory turnover — the number of times inventory is liquidated in a period (turnover) and calculates the number of days it takes to sell inventory. These ratios can help to determine if too little or too much inventory is on hand.
Also based on balance-sheet line items, leverage ratios measure a company’s likely ability to meet its debt obligations by looking at its after-tax income, excluding non-cash depreciation expenses, as compared to the company’s total debt obligations. These measures of financial health are among the most important since the more debt a company has, the riskier its stock is.
Debt to Equity: Total liabilities divided by total equity — a measurement of how much suppliers, lenders, creditors and obligators have committed to the company versus what the stockholders have committed. A lower percentage means that a company is using less leverage and has a stronger equity position; the reverse means you are highly leveraged.
Interest Coverage Ratio: Operating income divided by interest expense — an indication of how easily the company is able to cover the interest expense on outstanding debt. The lower the ratio, the more the company is burdened by the expense of carrying debt.
Profitability ratios come from data on both the profit-and-loss statement and the balance sheet. These ratios measure a company’s ability to generate a profit. They are most useful when compared to industry averages.
Gross Profit Ratio: Gross profit divided by net revenues — a measurement of the amount of profit as a percent of sales generated. It is a good indication of control over cost of sales and pricing and detects positive and negative trends.
Return on Assets: Net income divided by average total assets — an indication of how profitable a company is relative to its total assets and how well management is employing the company’s total assets. The higher the return, the more efficiently management is utilizing its asset base.
Return on Equity: Net income divided by average stockholders’ equity — highly regarded as a profitability indicator, net income is compared to average stockholders’ equity and measures how much the stockholders earned for their investment in the company. The higher the ratio, the more efficiently management is utilizing its equity base, and the better the return to investors.
The use of financial-ratio analysis can be beneficial in a number of ways. Utilizing ratios in the comparison of current periods versus prior periods provides a quick and accurate means of identifying trends, opportunities, and possible problems that may be emerging. You may also consider comparing your company’s ratios with ‘standard ratios’ within your industry to benchmark how your company is doing in relation to other companies.
These two views of your company’s performance can tell you a great deal about where your company is and where it needs to be. Your accountant and banker are also in a good position to help you identify those operational activities that impact each of the financial ratios. When you work with your management team, financial ratios can provide a focal point for strategic planning and execution.
Kristi Reale, CPA, CVA is a senior manager with Meyers Brothers Kalicka, P.C. in Holyoke. In addition to the tax, accounting, and consulting services she provides clients, she is also a certified valuation analyst.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.