Assess your business performance using financial ratios

Most companies involve a thorough examination of their economic framework at some stage. You can perform such an exercise through an extension project, small money reserves or a jump in expenditures. If you are borrower than usual when your sales rise, or if a client for instance wishes to place a big order and requests long-term loan conditions you may also decide to look at your economic framework.

One way to evaluate and improve your economic health is through your financial ratios carefully. The ratios are used to compare various elements of a company’s performance and how the firm is stacked within a given sector or region. You disclose fundamental data such as whether you have collected too much debt, stored too much stock or failed to collect due amounts quickly.

A popular use of economic ratios is if you look at your economic balance sheet to determine the stability and health of your company. The balance sheet shows what your business owns or gives (assets) and what it owes (loans). Bankers often include economic ratios in your credit contract. For example, your equity may have to maintain your debt above a certain proportion or your current assets above your current liabilities.

But ratios should not only be assessed when your banker is visiting. In order to keep up with evolving trends in your business, you should ideally check your monthly ratios. While conditions for distinct ratios exist, they are classified in 4 fundamental classifications. Here are ways to assess your business performance using financial ratios:

Liquidity ratios

These measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts, and provide a broad overview of your financial health.

The current ratio measures your company’s ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it 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.

The 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 this can vary depending 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 collect receivables more quickly.

A higher ratio may mean that your capital is being underutilized and could prompt you to invest more of your capital in projects that drive growth, such as innovation, product or service development, R&D or international marketing.

Efficiency ratios

Often measured over a 3- to 5-year period, these 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 such turnover occurs. This ratio can enable you to see where you might 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 tied up 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 and marketing.

Evaluating inventory ratios depends a great deal on your industry and the quality of your inventory. Ask yourself: Are your goods seasonal (such as 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.

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. A company with a higher profit margin than its competitor is usually 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 quite 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 the company’s various 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 infrastructure to do business. Service-based operations such as consulting firms will have a high ROA, as 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. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%.

A common analysis tool for profitability ratios 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 of 10% over the last 3 years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is performing relatively well. Nonetheless, you will still need to analyze the underlying data to establish the cause of the downturn and create solutions for improvement.

Leverage ratios

These ratios provide an indication of the long-term solvency of a company and to what 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, whether it comes from creditors or your own investments, for example. 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 determine 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). Industry Canada’s SME Benchmarking Tool offers basic financial ratios by industry, based on Statistics Canada small business profiles.

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, BDD consultants offers sound advice, which can help you interpret and improve your financial performance.

Beyond the numbers

It is essential to remember that ratios can determine your business performance only in one manner. Beyond the sector in which a business is located, location is also essential. The results and importance of a ratio may also be affected by regional variations in variables such as labor or transport cost. A sound financial analysis always involves a thorough review of the information used to determine the ratios and an assessment of the conditions that have produced outcomes.

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