Successful business owners will consistently evaluate the performance of the company, comparing it with the company’s historical figures, with its industry competitors, and even with successful businesses from other industries. However, to do a thorough examination of your company’s effectiveness, you need to look at more than just easily attainable numbers like sales, profits, and total assets. You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible. You must unlock the secrets of your financial statements.
This massive data overload could seem staggering. Luckily, there are many well-tested ratios out there that make the task a bit less daunting. Financial Ratio analysis helps you identify and quantify your company’s strengths and weaknesses, evaluate its financial position, and understand the risks you may be taking. In the last article, we talked about the value of presenting financial ratios on a financial dashboard. During this article, we will take a deeper dive into some of the financial ratios.
Financial Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can also be predictive, providing lead indications of potential problem areas.
Values used in calculating financial ratios are taken from the financial statements (balance sheet, income statement, and statement of cash flows). Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. They are categorized according to the financial aspect of the business which the ratio measures.
Liquidity ratios: Liquidity ratios measure the availability of cash to pay debt. Examples of liquidity ratios include:
Current ratio (Working Capital Ratio): Current assets / Current liabilities
Quick ratio: (Current assets – Inventory – Prepayments) / Current liabilities
Debt ratios: Debt ratios measure the firm’s ability to repay long-term debt. Examples of debt ratios include:
Debt ratio: Total liabilities / Total assets
Times interest earned ratio (Interest Coverage Ratio): EBIT / Annual interest expense
Profitability ratios: Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return. Examples of profitability ratios includes:
Gross margin, Gross profit margin or Gross Profit Rate: Gross profit / Net sales
Profit margin, net margin or net profit margin: Net profit / Net sales
Return on equity (ROE): Net income / Average shareholders’ equity
Return on assets (ROA ratio or Du Pont Ratio): Net income / Average total assets
Efficiency ratios: Efficiency ratios measure how quickly a firm converts non-cash assets to cash assets. Examples of efficiency ratios include:
Average collection period: Accounts receivable / (Annual credit sales / 365 days)
Average payment period: Accounts payable / (Annual credit purchases / 365 days)
Inventory conversion ratio: 365 days / Inventory turnover
Cash Conversion Cycle: Inventory conversion period + Receivables conversion period – Payables conversion period
Value ratios: Value ratios measure investor response to owning a company’s stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares. Examples of value ratios include:
Earnings per Share (Basic Formula) = Profit / Weighted average common shares
Payout ratio: Dividends / Earnings
P/E ratio: Market price per share / Diluted EPS
Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.
Financial ratio analysis is one way to turn financial statements, with their long columns of numbers, into powerful business tools. They also makes it easy to evaluate the performance of your business, to detect trends in your company and compare your performance with your peers.
I would love to hear from you. Please send me some ratios that you have found useful in your business.
If you would like to learn more about Financial Ratios, email me at DanYoung@b2bcfo.com for a complimentary session.
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