In my day-to-day job, I tend to come across a wide variety of business owners, which is one of the things I love about what I do. For the larger businesses, it is not uncommon to have segregated departments of accounting and finance, each led by seasoned industry professionals. Many smaller closely held businesses, however, do not have the resources to hire professionals to fill these roles. Rather, many small business owners tend to take on multiple roles, or assign multiple roles to employees in various functional areas of the organization where they may or may not have expertise.
One functional area that I often see get overlooked by many small business owners is the functional discipline of finance. I want to clarify that finance should not be confused with accounting. Many times, business owners will have an individual within the office reconcile the bank statements, post transactions to the general ledger, and serve in the A/R and A/P function, but this is a bookkeeping function not a finance function. I certainly don't intend to downplay the importance of bookkeeping, but many bookkeepers will prepare internal financial statements to give to their CPA and file it away when the task is complete. The area of finance looks forward. It serves to take the accounting information and analyze the historical data to determine the overall health of the organization, and what steps need to be taken in the future to increase overall value to the shareholders.
Business owners and the employees who support the financial aspects of the business should take note to actively engage in trend and ratio analysis. A very clear picture can be painted when financial information is tracked and compared over time (time-series analysis), and against industry "norms" (peer analysis). Financial ratio analysis is not difficult, and there are several key ratios that can tell a lot about a company's financial health.
Liquidity Ratios:
Liquidity ratios are intended to provide information about a firm's ability to pay its bills over the short run without undue stress. These ratios tend to focus on the relationship between current assets and current liabilities. The most widely used of these ratios is the current ratio. Defined as Current Assets divided by Current Liabilities, it measures short-term liquidity. While different industries demonstrate different current ratio norms, generally speaking, the higher the better. A current ratio less than 1 is generally a sign of poor liquidity and means that current assets are less than current liabilities, or more generally, the firm does not have the ability to generate short-term cash to meet its short-term obligations.
Another ratio commonly used, especially by companies who have a substantial amount of inventory, (such as a distributor) may want to look at the Quick Ratio. The Quick Ratio is essentially the current ratio, but deducts inventory from current assets. The ratio is calculated as current assets minus inventory divided by current liabilities. Inventory is generally perceived to be the least liquid (ease of converting an asset to cash) of the current assets and is designed to give a firm an indication of how heavily invested they may be in inventory. A very low quick ratio may signal short-term trouble in that the firm may have overbought, overproduced, or is not turning (selling) inventory quick enough to cover short-term obligations. Again, a ratio below 1 may not necessarily be a warning sign. Owners should take note to compare this ratio to the ratio of businesses of a similar size in the same industry.
Leverage Ratios:
Leverage Ratios are intended to address the firm's long-run ability to meet its obligations, or in other words, its financial leverage. The most common leverage ratio is the debt-to-equity ratio and it is calculated simply as Total Liabilities divided by Total Equity. A debt-to-equity ratio of 1.00 would suggest that the firm has financed operations with as much debt as equity. For example, a firm has $1000 of debt and $1000 of equity ($1000/$1000=1.00). Let's say debt increases to $2,000 due to taking out a loan and equity remains the same. In this case, the debt-to-equity ratio would increase to 2.00, which would suggest that for every dollar of equity, the firm uses twice as much debt to finance operations. As with many ratios, the normal range varies depending on the industry. Capital Intensive industries such as steel foundries and airlines often have high debt to equity ratios because they are generally entering into long-term financing arrangements to acquire revenue producing assets. A word of caution, however, debt-to-equity ratios above 4 to 5 may start to signal high financial leverage, which for many, translates into increased risk in the eyes of creditors and lenders. High financial leverage often carries fixed costs that may be difficult to meet if revenues, margins, and/or expenses move in a negative direction.
Efficiency Ratios:
These ratios are intended to describe how efficiently, or intensively, a firm uses assets to generate sales. One of the most common is the inventory turnover ratio. The inventory turnover ratio is commonly defined as Cost of Goods Sold divided by Inventory (or average inventory). A ratio of 4, for example, tells us that the firm turned over its entire inventory 4 times during the fiscal period being measured. Why is this important? Theoretically, the more a firm turns over its inventory the more cash is being generated. It is also important, especially when compared over multiple periods, in telling the firm whether there may be an inventory management problem such as slow moving SKUs or issues in the purchasing department.
Coupled with the Inventory Turnover Ratio is the Days Sales in Inventory, which is defined as 365 days divided by the Inventory Turnover Ratio. Using our example above of 4, the Days Sales in Inventory Ratio would be 91.25 days (365/4=91.25). This result indicates that on average, the company took 91.25 days to fully turn over its inventory, or conversely, inventory sits for 91.25 before being sold. Generally, the lower the number of days the better as this would indicate the company is converting inventory to cash more frequently thereby generating cash more frequently. Again, comparison with industry norms is the best way to determine whether this area of the business is operating as efficiently as it should be.
Another common efficiency ratio is the Accounts Receivable Turnover Ratio, which is defined as Sales/Accounts Receivable (or average A/R). This ratio tells the company how fast they collect on sales made on credit. If a company demonstrates a ratio of 10, the ratio would indicate that the company collected on outstanding credit and lent the money again 10 times during the year. The meaning of the ratio is more easily understood if put in terms of Days sales in A/R, which is defined as 365/Receivables Turnover Ratio. In our example, the company demonstrates 36.5 A/R days (365/10), which implies the company takes, on average, 36.5 days to collect on its receivables. Like the Days sales in inventory, a lower number is better as it indicates the company is very good at collecting on money that is owed, which thereby increases the amount and frequency in which cash is collected.
Profitability Ratios
Profitability ratios measure how efficiently the company uses its assets and how efficiently the firm manages operations. There are three common ratios; profit margin, return on assets and return on equity. Gross Profit margin is simply calculated as gross profit divided by net income. This ratio can also be calculated as net profit margin (net income/sales) or operating margin (operating profit divided by sales). These ratios tell us how much profit the firm is producing per dollar of sales. For example, if a company generates $1,000,000 in sales and $20,000 the net margin would be 2%, or more generally, generates $.02 of profit for every dollar of sales.
Return on assets (ROA) measures the amount of profit per dollar of assets, and can be defined as net income/total assets (or avg total assets). Using the numbers above, if the company generated net income of $20,000 on assets of $500,000, return on assets would be .04 (or 4%). In this case, the company generates $.04 of profit for every $1 of assets. Consequently, the return on equity (ROE) measure is the same calculation only it places profit in terms of total equity (net income divided by total equity) and measures how the stockholders fared during the year.
It is important to note that I have only outlined some of the more common ratios used by financial managers to measure firm performance. There are many ratios that a company can use, and there are many different variations depending on the source. After working with some of the simpler ratios, like the ones above, a company should work with other ratios to determine which ones are most applicable for their particular business.
A financial manager need not memorize these ratios, but rather, enter them into an excel spreadsheet and calculate them periodically as necessary. Once several periods of data are established trends or "red flags" will start to emerge, which will help pinpoint the areas of the organization that may need attention.
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