Wouldn’t it be nice to convert the raw data from your financial statements into meaningful information that can help you manage your business?
Financial ratios are the answer! They’re a powerful and widely-used tool for analyzing the financial health of your company. Although the name “financial ratios” may sound scary or complicated, and some of the specific names of these ratios may be unfamiliar (“efficiency ratios”, “liquidity ratios”, etc.), none of the information we’ll be sharing in this post is actually very difficult to calculate or very complicated to use. Best of all, the payoff of understanding these numbers can be enormous!
By analyzing the profitability of your business using financial ratios you’ll be able to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry. Once you get comfortable with these tools you’ll be able to turn the raw numbers in your company’s financial statements into information that will help you better manage your business. And who doesn’t want that?
So here are three main ratios that will help you analyze the profitability of your business, which can help with many business tasks like an expansion project, low cash reserves, a jump in expenses, or, for example, if a customer wants to place a large order and is asking for longer-than-normal credit terms.
These ratios measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts. They also give your business a broad overview of it’s financial health.
The current ratio, also known as the working capital ratio, measures your company’s ability to generate cash to meet your short-term financial commitments. It’s calculated by dividing your current assets like cash, inventory and receivables by your current liabilities, including your line of credit balance, payables, and current portion of long-term debts. Basically: What You Have divided by What You Owe. Simple, right?
The quick ratio measures your business’ ability to access cash fast when you need it. This is a calculation that will help you to understand how well you’re equipped to support immediate demands. This is also called the acid test. The quick ratio divides current assets (excluding inventory) by current liabilities (excluding current portion of long-term debts). How do you know if you’ve got a good rating? A ratio of 1.0 or more is usually acceptable, but this can change depending on your industry.
But… If you find that your ratio calculation comes out comparatively low then your business could have trouble meeting obligations and may not be able to take advantage of opportunities that need quick cash. Uh oh!
So what can you do to fix this?
Paying off your liabilities is a great place to start and can help improve this ratio. How? It’s a good idea to try to delay non-critical purchases. You might also consider long-term borrowing to repay short-term debt. Another good option is to review your credit policies with clients and adjust them if needed so you can collect receivables faster.
So what if my ratio calculation is comparatively high?
Well, a higher ratio could mean that your working capital is not being used properly. If you come out with a high ratio, it’s a good idea to invest more of your cash in projects that drive growth like innovation, product or service development, research and development, or international marketing. Spending money can be fun and productive at the right times!
But don’t forget that what makes up a healthy ratio differs from industry to industry. For instance, a clothing store’s goods typically lose value quickly due to changing fashion trends. But, these goods are easily liquidated and have high a turnover rate. This means that small amounts of money are continuously coming in and going out so in a worst-case scenario liquidation is actually not too hard. Thus, a clothing company could easily function with a current ratio that is close to 1.0.
But a different industry like an airplane manufacturer would need a much higher liquidity ratio because they have high-value, non-perishable assets including work-in-progress inventory and extended receivable terms. These types of businesses necessitate carefully planned payment terms with customers so the current ratio should be much higher to enable coverage of short-term liabilities.
These ratios are usually measured over a 3- to 5-year period and provide extra insight into areas of your business like collections, cash flow, and operational results.
If you’re an inventory-reliant business then this ratio can really be a make-or-break factor for your business’ success. Inventory turnover examines how long it takes for inventory to be sold and replaced during the year. It’s calculated by dividing total purchases by average inventory in a given period. Of course, the longer the inventory sits on your shelves, the more it costs you. It’s important to analyze your inventory turnover seeing as gross profit is earned each time turnover takes place. This ratio can allow you to see where you might improve your buying practices and inventory management. Ch-ching!
By using this ratio calculation you could assess your purchasing patterns and your clients to figure out ways to minimize the amount of inventory that stays on your shelves. Perhaps it’ll be a good idea to turn some of your obsolete inventory into cash by selling it off at a discount to certain clients. This ratio can also help you see if your levels are too low which means you’d be missing out on sales opportunities. Yikes!
Another helpful ratio is the inventory to net working capital ratio because it can ascertain if you have too much of your working capital tied up in inventory. It’s calculated by dividing inventory by total current assets. Typically, the lower the ratio, the better. If you improve this ratio it will allow you to invest more working capital in growth-driven projects like export development, research and development, and marketing—so you see why it’s important!
Once again, this ratio depends a great deal on your industry and the quality of your inventory.
An important questions to ask yourself when calculating this ratio is:
Are your goods seasonal (like pool equipment) either perishable (like food or some cosmetics) or prone to becoming obsolete (like fashion or tech)?
Based on the answer, these ratios will differ a great deal. But, regardless of the industry, inventory ratios can you help you improve your business efficiency and that’s what counts!
Another key ratio is the average collection period. It examines the average number of days customers take to pay for your products or services. It’s calculated by dividing receivables by total sales and multiplying by 365. To collect payments more efficiently, it can be helpful to establish clearer credit policies and set collection procedures. For example, to prompt your clients to pay on time, you can give them incentives or discounts and you should also compare your policies to those of your industry to make sure you’re being competitive.
This is one of the most frequently used tools when it comes to financial ratio analysis. Profitability ratios are used to figure out the company’s bottom line and its return to its investors. Profitability measures are important to both company managers and you, the owner, because profitability ratios portray a company’s overall efficiency and performance.
Profitability ratios are divided into two types: margins and returns. Ratios that demonstrate the margins represent your business’s ability to translate sales dollars into profits at different stages of measurement. While ratios that show returns represent your business’ ability to measure the overall efficiency of your business when it comes to producing returns for your shareholders.
Net profit margin measures how much a company earns (usually after taxes) relative to its sales. A business with a higher profit margin than its competitor is often more efficient, flexible, and better equipped to take on new opportunities. Nice!
Operating profit margin, which can also be called coverage ratio, measures earnings before interest and taxes. The results can differ quite a bit from the net profit margin as a result of the impact of interest and tax expenses. By determining this margin, you can better assess your ability to expand your business through additional debt or other investments.
Return on assets (ROA) ratio is used to figure out how well management is employing the company’s various resources (assets). It’s calculated by dividing net profit (before taxes) by total assets. The number will change widely across different industries. For example, a capital-intensive industry like the railway industry will yield a low return on assets because they need expensive infrastructure to conduct business. But, service-based operations like a consulting firm will have a high ROA since they require minimal hard assets to function.
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. It’s calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity and multiplying the result by 100%.
An important part of ratio analysis when it comes to profitability ratios is cross-sectional analysis. This compares ratios of several companies from the same industry. Let’s say your business experienced a downturn in its net profit margin of 10% over the last 3 years. You might he thinking that’s bad news! However, if your competitors have experienced an average downturn of 21%, well then your business is actually performing quite well! However, in this case it would still be important to analyze the underlying data as a way to figure out the cause of the downturn and create solutions to improve.
The Sum and Substance
As you can see there are so many financial ratios! From liquidity ratios, to debt or financial leverage ratios, to efficiency or asset management ratios, it’s no surprise that entrepreneurs and business owners can get caught up in the numbers and have trouble seeing the big picture.
Of course, a great accountant can help you to figure all this out. (Hi!) There’s also a method that business owners can use to summarize all of the ratios; it’s called the Dupont Model. The Dupont Model can show you where the component parts of the Return of Assets (or Return on Investment ratio) comes from as well as the Return on Equity ratio and this model can be very helpful in determining if financial adjustments need to be made. There are also a variety of online ratio calculators, which can help make ratio calculation fast and efficient.
However, it’s important to remember that ratios are not the only way to figure out your business’s financial performance. This is something that I can help you with as your accountant by looking at all of the key factors. Not only is the industry you’re in important, but location can also play a role and so can regional differences in factors like labour or shipping costs. In order to make a solid financial analysis you need to closely examine the data used to establish the ratios in addition to assessing the circumstances that produced those results.
Here at the Number Works, we understand that as a small business owner you might not have the time or the expertise to conduct a thorough analysis of your business using financial ratios—and that’s ok! We’re always excited to crunch numbers and get behind your business’s success. With our numbers know-how and your savvy entrepreneurial skills, your business is sure to thrive! If you have any questions, please don’t hesitate to contact us today.