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Even
the most business-savvy person is tempted to ask,
“What does this mean?” when faced with rows of
numbers stacked into pages of columns on financial
statements. Fortunately, some quick ways exist
to analyze financial statements and get an understanding
of this data. Known as financial ratios, these
rules of thumb can help you:
- Benchmark operational
standards against industry averages and your
competitors;
- Analyze overall
financial and operational health; and
- Predict the
results of future operations.
- You can also
use financial ratios to measure:
- Liquidity (ability
to pay current bills);
- Activity (rates
of inventory turnover and accounts receivable
collection);
- Leverage (ability
to borrow money and pay off debt); and
- Profitability
(performance and efficiency at turning a profit).
In your analysis,
you can choose from a variety of financial ratios.
Here are some of the most common.
Current
Ratio
Equation:
current assets ÷ current liabilities
What you can
learn: How well a company is able to pay
its bills — short-term solvency. It indicates
the extent to which the claims of short-term creditors
are covered by assets expected to be converted
into cash in the near future.
Quick
Ratio
Equation:
(current assets – inventory) ÷ current liabilities
What you can
learn: What percentage of assets can
be quickly turned into cash. Inventories are
typically the least liquid of a company’s current
assets, and that makes them the assets on which
losses are most likely to occur in the event of
liquidation. Therefore, the quick ratio is a measure
of the firm’s ability to pay off short-term obligations
without relying on the sale of inventories.
Inventory
Turnover
Equation:
cost of goods sold ÷ average inventory
What you can
learn: Frequency with which inventory
is sold. The ratio depends on the industry
and in some cases, even the time of year. Faster
turnovers are generally viewed as a positive trend
because they increase cash flow and reduce warehousing
expense.
Debt
to Equity
Equation:
total liabilities ÷ net worth
What you can
learn: Relationship of dollars creditors
contribute (debt) to capital invested by owners
(equity). This ratio indicates the degree
of financial leverage that you are using to enhance
your return. A rising ratio could mean that new
debt should be restrained. Most investors feel
safer investing in a well-capitalized company
than in a highly leveraged business. A company
is generally considered well-capitalized if the
owners generally have a significant amount of
their own funds at stake.
Return
on Equity
Equation:
net profit ÷ net worth
What you can
learn: How well owner-supplied funds are
being used to generate profits. The higher
this number, the better. It shows what you have
earned on your investment. The higher the ratio,
the better the funds are being used to generate
a good return on investment for shareholders and
the greater the profit.
One
Caveat
While benchmarking
against other companies can be valuable, it also
presents pitfalls. Comparing apples with oranges
can distort results. Look out for differences
such as:
- Accounting
methods (for example, using the first-in, first-out
instead of last-in, first-out inventory method
leads to different inventory and cost-of-sales
figures on the income statement).
- Fiscal year-ends
(especially important for seasonal companies).
- Methods of
computing financial ratios (for example, before-tax
basis vs. after-tax basis).
Who
Else Uses Financial Ratios?
Business owners
and managers aren’t the only ones who can benefit
from looking at financial ratios. So can:
- Investors,
to make informed and intelligent investment
decisions.
- Corporate
financiers, to spot potential takeover targets.
- Creditors,
to evaluate business loan risks.
- Investment
advisors and banks, to find prosperous companies
that might need their services.
Take
Advantage of Financial Ratios
In addition to using
ratios to evaluate the performance of your own
company and benchmark it against the competition,
you can use them when considering the financial
health of potential business partners and the viability
of investment options. Keep in mind, though, that
financial statements often provide only one part
of the big picture (see our article, Building
a Better Dashboard, in the January-February
2002 Business Performance Advantage) – true
performance management relies on other means of
measurement. Give us a call so we can answer any
questions you may have about calculating or interpreting
financial ratios or improving performance measures.
We can help you use all of these valuable tools
to enhance your business’s future. |
