You probably spend a lot of time analyzing your business. Far
too many shop owners, however, neglect one of the best ways to
evaluate a company: the use of financial ratios”?including liquidity
ratios, profitability ratios, and activity ratios.
Before getting into the details, let's consider how these ratios
should be used. The most useful analysis is achieved by comparing
the results of your financial analysis over different periods of
time. For example, ratio analysis on your annual financial statements
should be discussed in the context of how things have
changed since the prior year. In addition, comparative analysis
also can be done on a quarterly
and a monthly basis if
you wish to more accurately
track the financial health of
your company.
You can also use financial
ratios to evaluate the
performance of your business
against standards that
have been established in
your company's specific
market niche (to the extent
that the information is
available). Comparing and contrasting the results of your business
with industry norms can be a very useful tool in financial
benchmarking. Keep these thoughts in mind as I take you
through a few ratios that should prove useful.
Liquidity ratios
Liquidity ratios measure the extent to which a company can
quickly liquidate its assets and generate cash in order to cover
short-term liabilities.
Current Ratio = current assets ?? current liabilities
This ratio measures how well a company can manage its shortterm
cash needs. Simply stated, can the company pay its bills? If
this ratio is substantially over 1.0, cash flow will typically be positive
and working capital will be available for the day-to-day business
needs. If, however, this ratio dips below 1.0, cash flow will become
tight and the business may begin to suffer from a cash crunch.
Quick Ratio = quick assets (current assets – inventories)
??current liabilities
The quick ratio is often used by banking and financial institutions
to measure true liquidity. Because inventories are
less easily converted to cash, the quick ratio provides a more
accurate measure of the business's ability to meet immediate
cash-flow demands.
Profitability ratios
Profitability ratios generally show how successful a company is
in terms of generating returns or profits on the investment that
it has made in the business.
Profit Margin = net income ?? sales
This ratio is probably the most popular and widely utilized of all
ratios. The measure of net income generated by sales is always an
important number to focus on when managing a business. This
ratio provides the snapshot of any company's fiscal health.
Return on Assets = net income ?? average total
assets [(beginning assets + ending assets) ?? 2]
This ratio indicates asset utilization by a business in terms of
income generated. For example, if a business increases profitability
from 6% to 8%, that would indicate a positive trend. If,
however, the business doubled its assets in that same year but
only increased profitability by 2 points, the return on assets will
show a negative trend and unfavorable results. This ratio will
identify companies that are purchasing significant assets to
maintain their profit margins.
Return on Equity = net income ?? average shareholders'
equity [(beginning shareholders' equity
+ ending shareholders' equity) ?? 2]
This ratio is very similar to the return on assets. The return
on equity will indicate the measure of profitability as a proportion
of the amount of equity infused into the company. If the
company's owners contribute a significant amount of equity to
the business in order to provide working capital, inventory,
assets, etc., and the profit margin remains the same, this ratio
may indicate that equity is perhaps not being utilized as well as
you would like”?especially if you are the contributor!
Activity ratios
Activity ratios measure a company's ability to utilize cash and
inventory to generate sales.
Accounts Receivable Turnover Ratio = sales ?? average
accounts receivable [(beginning A/R + ending A/R) ?? 2]
In addition to tracking your A/R aging reports, try calculating
the A/R turnover ratio on a regular basis and chart the progress.
While the A/R aging report provides an immediate snapshot of
where your collection efforts should be focused, the A/R turnover
ratio illustrates how effective your collection efforts are.
For example, at the end of a given month, your work on collecting
outstanding accounts might indicate an improvement in
the overall balance of accounts receivable. This is good! If, however,
sales have dropped down in that same month by a larger
amount, the A/R turnover ratio calculation will indicate that collection
efforts need to improve. This ratio presents you with an
overall picture of how well the collection efforts are going in relation
to the increase or decrease of sales in a given month.
Inventory Turnover Ratio = cost of goods sold
??average inventories [(beginning inventories
+ ending inventories) ?? 2]
The inventory turnover ratio offers valuable data regarding the
purchasing levels of inventory. It provides valuable insight regarding
inventory utilization. Like the other ratios, this calculation is
best used when comparing with other periods. If this ratio is
tracked for an extended period of time, you can then begin to target
the turnover ratio desired, and measure results accordingly.
Indicating the trends
Remember: By themselves, these financial ratios serve no useful
purpose”?their job is to indicate trends in the financial position of
your company. Using financial-ratio analysis requires discipline
and some time, but if you use it, you will gain a better understanding
of your business”?which should make you a better manager.
Marty McGhie (marty@ferraricolor.com) is VP finance/
operations of Ferrari Color, a digital-imaging center with Salt
Lake City, San Francisco, and Sacramento locations.