Financial Ratios: Why They Matter

It is surprising how many business owners and leaders do not keep an eye of their financial ratios, a fundamental barometer of the health of your business.

Whether you track these ratios or not, others will. Potential buyers, bankers and investors will analyze trends and compare your company’s ratios to industry peers. Their determination of value and/or potential investment is ultimately at stake. But, perhaps even more importantly, understanding your financial ratios can lead to improvements in business operations. If a particular ratio is lagging the industry or trending negatively, there is most likely an action you can take that will realign the metric and improve operations.

Financial ratios fall under four general categories according to the information they provide:

• Liquidity Ratios measure how well a business can meet its obligations in the short term.
• Efficiency Ratios measure how well a company utilizes its assets and liabilities.
• Profitability Ratios measure a company’s ability to generate earnings relative to sales, assets and equity.
• Leverage Ratios measure the company’s debt usage and how well it can afford its debt.

Which Ratios Should You Keep an Eye On?

There are a number of ratios you can track. Listed below are some of the key ratios and what you can do if they are getting off track.

• Current Ratio: The current ratio is a measure of solvency. This ratio indicates the amount of assets available to meet current obligations. The higher the ratio, the greater the company’s liquidity.Strong cash management policies and procedures can improve this ratio.
• Days Receivable:  This ratio provides the average collection period for sales. The lower the number of days, the more quickly the company is collecting its receivables. Tighter payment terms and/or more aggressive collections can improve this ratio.
• Days Inventory:  This ratio provides the average number of days an item is in inventory. A higher number of days implies excess inventory due to obsolescence or poor sales. A lower number implies either strong sales or inadequate inventory levels. Eliminating excess inventory and/or better inventory buying and management systems can improve this ratio.
• Pretax Net Profit Margin: This ratio indicates the amount of profit the company earns for every dollar of sales generated. The higher the pre-tax profit margin, the more profitable the company.Improving gross margins and tight expense control can improve this ratio.
• Return on Assets: This ratio indicates the number of cents earned on each dollar of assets. It measures the effectiveness of management in employing available resources. The higher the ratio, the more productive the company’s use of assets and the more profitable the business. Improve efficiency in operating your plant and equipment and you will improve your return on assets.
• Debt to Equity: This ratio indicates what proportion of equity and debt the company is using to finance its assets. It denotes the relationship between capital contributed by creditors and that contributed by owners. The lower the ratio, the less leveraged the company. To reduce the debt to equity ratio, the company must reduce debt and/or increase equity, in essence a recapitalization of the company.

Financial ratios provide a comprehensive picture of the health of your business. It behooves every business owner and/or leader to know, understand and work to improve them.

If you would like assistance understanding your financial ratios and developing a plan to improve performance, please give us a call. We would be happy to help.