Understanding Key Business Ratios

For business owners, it is important to be able to examine the financial structure and health of their business. Although there does not need to be any negative concerns with a business to prompt an owner to want to take a deeper look into the finances of the business, problematic situations may arise that may cause one to perform this task. If a business begins to realize that its cash reserves are extremely low, or there has been a significant increase in expenditures, then analyzing the financial health of your business can bring forth helpful information to get you back on track. A positive reason to analyze your business would be if you are looking to expand or evolve. Understanding the financial situation of your business will let you know if the project is something you are ready for or not.

Using financial ratios is one way to analyze the financial wellness of your business as well as recognize how it may be improved. In addition to getting various pieces of information about your business, ratios also give you an idea of how the business compares to other companies within the same industry and/or area.

Frequently, financial ratios are used when a business needs to borrow funds. Lenders will assess how stable a company is by looking at its balance sheet, specifically the assets and liabilities. Keeping your equity more than a certain percent of your debt or keeping your current assets above a certain percentage of your current liabilities, is important to lenders. It is a good thing to be financially stable if you are looking for a business loan, but a business owner should be evaluating their company’s health on a consistent basis.

Current Ratio

The current ratio is a liquid ratio. Liquid ratios measure the amount of cash or other assets that are easily converted that a business has. The current ratio determines a company’s ability to pay short-term (due in less than 1 year) financial obligations. Current ratio is computed by dividing current assets (cash/cash equivalents, inventory, accounts receivables, short-term investments, etc.) by current liabilities (accounts payable, sales tax payable, payroll taxes payable, accrued expenses, etc.). If a company’s current ratio is less than 1, this indicates that its debts due within a year are more than current assets. Obviously, a low current ratio is a bad thing because this can mean that a business may have issues fulfilling its obligations and may not be able to cease the moment when opportunities come up that require quick funding. This problem can be fixed by focusing on paying off some of your liabilities. Also, you may want to examine your cash flow avenues to see if there can be anything improved in order to increase revenue or collect receivables faster. A high current ratio (greater than 3) could indicate that you are not properly utilizing your capital. You may benefit by looking into ways to drive growth in your business, like spending on market research, developing new products, or investing more into advertising.

The Downside

Although the current ratio seems straight forward, depending on what industry you are in, it can be difficult applying its principles. For example, in certain industries it might be more common to have receivables with 90-day terms, whereas in another industry receivables with 30-day terms might be more common. Without looking deeper into the items, it may seem that the company with 90-day terms is better off based on the current ratio, as this company will likely have more current assets because it will be carrying higher amounts in receivables. This is why you must compare your current ratio to companies in the same industry.

Another downside to the current ratio is it does not consider what the current assets or current liabilities total is made up of. If there are 2 companies in the same industry that have identical current ratios, how do we know which one is in better shape? As an example, let’s just say one of the companies has significantly more cash and cash equivalents than the other, which has more in inventory? The company with more cash and cash equivalents theoretically will be in better shape because cash is the most liquid asset. On the other hand, the company with more inventory has a less liquid asset as it will take time to sale inventory.

Net Profit Margin

Net profit is the percentage of revenues remaining after all expenses have been paid. It is computed by dividing net income by revenue. This answers the question of, how much does a business earn relative to its sales? Having a high gross profit margin usually means that a business is operating efficiently. Generally, a company with a net profit margin of over 10% is considered to be doing very well, but just like other measurements, the industry must be considered when drawing conclusions. An important element of net profit margin is you can quickly determine if your operating and overhead costs are at a good place.  If the net profit margin is low, then normally a business needs to cut cost in some area. A low net profit margin can also mean that in comparison to other business in the industry, you may need to increase prices or change other key operating factors in order to increase profitability.  Net profit margin is one of the most common key indicators of a company’s financial health.

Return on Equity

Return on equity (ROE) is a measurement that gives an owner/shareholder insight on how well a business is doing as it concerns the investments they have made. It tells them how much money is earned per dollar they invested. To calculate return on equity, divide the net income of a business after taxes by the total shareholders’ equity. Shareholders equity is found on the balance sheet as assets minus liabilities. Return on Equity is a great measure of how good you or your management team are using the company’s assets to create profits. Once again in order to use the measurement you must consider the industry. Whether return on equity is at a good or bad place will depend on what is normal for businesses in a specific industry.  One can generally conclude that their return on equity is good if it has consistently been tracking the same or higher than the average of other companies in the same industry. Outside of comparing yourself to businesses in the same industry, you can compare your return on equity to the long-term average of the S&P 500, which is roughly 10%. This would be considered acceptable. On the other hand, if you are below 5%, this would be considered a poor return on equity.

Debt to Equity Ratio

Debt to equity ratio shows the proportion of owner/shareholders’ equity and debt being used to finance a business’s assets. It is calculated by dividing total liabilities by total shareholders’ equity. The necessary information is found on the balance sheet. A low debt to equity ratio shows that company is using more equity rather than debt to finance business operations. A higher debt to equity ratio indicates greater risk of not being able to meet obligations or even bankruptcy if the business experiences tough times. This is because payments must be made to lenders even if the business has not made enough profits to make the payments. As with the other ratios that have been discussed debt to equity ratio is best used when comparing companies within the same industry. There are some industries that naturally will carry higher levels of debt than others. Also, having large amounts of long-term debt in comparison to short-term debt is a bigger issue, because of the greater financial burden it puts on a company. So, the type of debt must be considered when analyzing a business based on this ratio.

The ratios discussed here great to consider when analyzing your business. The information here is not all inclusive for each ratio, there are more things to consider outside of what is discussed here. Be sure to consult with an experienced business analyst in order to gather the most helpful information about your business using these ratios. In addition to other techniques, Molen & Associates helps businesses build their financial future by analyzing the company’s financial statements using these ratios and others. Do not put off seeking help if you just cannot seem to experience the kind of growth from your business that you desire.

Arthur Harrison
Tax Advisor & Accounting