Most businesses at some point or another face opportunities that require an in depth look at their financial structure. This may be due to an expansion project or simply a need for additional financing.
And often the signals are clear:
- you may have low cash reserves or your expenses are increasing
- you need to extend longer than normal credit terms to a customer for a large order
- you may find yourself borrowing more frequently as your sales are increasing
One way to analyze your financial health and identify where you can improve it is by looking closely at your financial ratios. Ratios are used to make comparisons between different aspects of a company's performance or within a particular industry or region. They reveal very basic information such as whether you've accumulated too much debt, are stockpiling too much inventory or not collecting receivables fast enough.
Ideally, you should review your ratios on a monthly basis in order to keep abreast of changing trends in your company. The most common example of the importance of financial ratios is when a lender determines the stability and health of your business by looking at your balance sheet. The balance sheet provides a portrait of what your company owns or is owed (assets) and what you owe (liabilities). Bankers will often make financial ratios a part of your loan agreement. For instance, you may have to keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities.
Although you'll find different terms are available for different ratios, these are the basic 4 categories:
Liquidity ratios
These ratios measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts and they give a broad overview of your financial health.
Current ratio (also called the working capital ratio) measures your company's ability to generate cash to meet your short-term financial commitments. The current ratio is calculated by dividing your current assets such as cash, inventory, and receivables by your current liabilities such as line of credit balance, payables, and current portion of long term debts.
Quick ratio measures your ability to access cash quickly to support immediate demands. Also known as the acid test, the quick ratio divides current assets (excluding inventory) by current liabilities (excluding current portion of long term debts). A ratio of 1.0 or greater is generally acceptable, but depends on your industry.
A comparatively low ratio can mean that your company might have difficulty meeting your obligations and may not be able to take advantage of opportunities that require quick cash. Paying off your liabilities can improve this ratio; you may want to delay purchases or consider long-term borrowing to repay short-term debt. You may also want to review your credit policies with clients and possibly adjust them to improve the time it takes to collect receivables.
A higher ratio may mean that your capital is being underutilized. In this case, you could invest your capital in projects that drive more growth, such as innovation, product or service development, R&D or reaching international markets.
Efficiency ratios
Often measured over a 3 to 5 year period, these ratios give additional insight into areas of your business such as collections, cash flow and operational results.
Inventory turnover looks at how long it takes for inventory to be sold and replaced during the year. It is calculated by dividing total purchases by average inventory in a given period. For most inventory-reliant companies, this can be a make or break factor for success. After all, the longer the inventory sits on your shelves, the more it costs.
Assessing your inventory turnover is important because gross profit is earned each time inventory is turned over. This ratio can enable you to see where you can improve your buying practices and inventory management. For example, you could analyze your purchasing patterns as well as your clients to determine ways to minimize the amount of inventory on-hand. You might want to turn some of the obsolete inventory into cash by selling it off at a discount to specific clients. This ratio can also help you see if your levels are too low and you're missing out on sales opportunities.
Inventory to net working capital ratio can determine if you have too much of your working capital invested in inventory. It is calculated by dividing inventory by total current assets. In general, the lower the ratio, the better. Improving this ratio will allow you to invest more working capital in growth-driven projects such as export development, R&D or marketing.
Evaluating inventory ratios depends a great deal on your industry and the quality of your inventory. Ask yourself: are your goods seasonal (ski equipment), perishable (food), or prone to becoming obsolete (fashion)? Depending on the answer, these ratios will vary a great deal. Still, regardless of the industry, inventory ratios can you help you improve your business efficiency.
Average collection period looks at the average number of days customers take to pay for your products or services. It is calculated by dividing receivables by total sales and multiplying by 365. To improve how quickly you collect payments, you may want to establish clearer credit policies and a set of collection procedures. For example, to encourage your clients to pay on time, you can give them incentives or discounts. You should also compare your policies to those of your industry to ensure you remain competitive.
Profitability ratios
These ratios are used not only to evaluate the financial viability of your business, but are essential in comparing your business to others in your industry. You can also look for trends in your company by comparing the ratios over a certain number of years.
Net profit margin measures how much a company earns (usually after taxes) relative to its sales. In general, a company with a higher profit margin than its competitor is more efficient, flexible and able to take on new opportunities.
Operating profit margin also known as coverage ratio measures earnings before interest and taxes. The results can be very different from the net profit margin due to the impact of interest and tax expenses. By analyzing this margin, you can better assess your ability to expand your business through additional debt or other investments.
Return on assets (ROA) ratio tells how well management is utilizing all the company's resources (assets). It is calculated by dividing net profit (before taxes) by total assets. The number will vary widely across different industries. Capital-intensive industries such as railways will yield a low return on assets, since they need expensive assets to do business. Service based operations such as consulting firms will have a high ROA: they require minimal hard assets to operate.
Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. It tells the shareholders how much the company is earning for each of their invested dollars and is calculated by dividing the equity in the company by net profits (usually before tax).
A common analysis tool for profitability ratios used today is cross-sectional analysis, which compares ratios of several companies from the same industry. For instance, your business may have experienced a downturn in its net profit margin by 10% over the last 3 years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is actually performing better than the industry as a whole. Nonetheless, you will still need to analyze the underlying data in order to establish the cause of the downturn as well as create solutions for improvement.
Leverage ratios
These ratios provide an indication of the long-term solvency of a company and to which extent you are using long-term debt to support your business.
Debt-to-equity and debt-to-asset ratios are used by bankers to see how your assets are financed, for example, by creditors or through your own investments. In general, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities.
Accessing and calculating ratios
To calculate your ratios, you can use a variety of online tools such as BDC's ratio calculators, although your financial advisor, accountant, and banker may already have the most currently used ratios on hand.
For a fee, industry-standard data is available from a variety of sources, both printed and online, including: Dun & Bradstreet's Industry Norms and Key Business Ratios, RMA's Annual Statement Studies, and Statistics Canada (search for Financial Performance Indicators for Canadian Business). Strategis' Performance Plus offers basic financial ratios by industry, based on Statistics Canada's small business profiles from 1997, 1995, and 1993.
Interpreting your ratios
Ratios will vary from industry to industry, and over time, interpreting them requires knowledge of your business, your industry, and the reasons for fluctuations. In this light, BDC Consulting offers sound advice, which can help you interpret and improve your financial performance.
To help you understand why ratios can easily vary from one industry to another, see the examples below. A current ratio measures your ability to pay your debts over the next 12 months; a ratio of 1.0 or greater is generally acceptable.
- A clothing story will have goods that quickly lose value because of changing fashion trends. However, these goods are easily liquidated and have high turnover. As a result, small amounts of money continuously come in and go out, and in a worst-case scenario, liquidation is relatively simple. This company could easily function with a current ratio close to 1.0
- An airplane manufacturer, on the other hand, has high-value,
non-perishable assets such as work-in-progress inventory as well as extended receivable terms. Businesses with these characteristics need carefully planned payment terms with customers; the current ratio should be much higher to allow for coverage of short-term liabilities.
Beyond the numbers
It's important to keep in mind that ratios are only one way to determine your financial performance. Ratios may vary widely depending on your industry category and location. Regional differences in such factors as labor or shipping costs may also affect the result and the significance of a ratio. Sound financial analysis always entails closely examining the data used to establish the ratios as well as assessing the circumstances that generated the results.
Although your financial ratios reveal a lot about your company's performance, other factors, such as your sales cycle, can also give you insight into your operational efficiency.
