Financial Ratio Analysis
The financial statements provide information about business financial results. These can be used to calculate financial ratios to provide additional insight into the health of a business. A business can also measure non-financial metrics to analyze operating performance, such as employee turnover, safety incidents, or asset utilization. However, in this article we will focus on some of the key financial ratios.
These ratios are typically expressed as a percentage.
Return on Capital Employed = Net Income ÷ Capital Employed
Capital employed is equity plus long term debt and represents the investment in the business. The average capital employed at the beginning and end of the financial statement period is often used in the denominator. Return on capital employed measures how much profit a company generates for each dollar of capital invested and a higher number indicates greater profitability. This metric can be used to compare the return from reinvesting profits back into the business versus alternative investment opportunities.
Return on Sales = Net Income ÷ Revenue
This ratio measures how much profit is generated for each dollar of sales, and a higher number indicates that a greater percentage of revenue is flowing to net income.
Gross Margin = Gross Profit ÷ Revenue
Gross Profit is revenue minus cost of goods sold. This ratio is a good measure of sales pricing because it indicates the mark up over the costs to produce goods and services. It also shows the percentage of revenue that is available to pay overhead expenses, with the residual amount being net income.
Current Ratio = Current Assets ÷ Current Liabilities
Working capital is calculated as current assets minus current liabilities and indicates the net short-term funds available to finance business operations. The current ratio is a similar metric but can be more useful when comparing companies across industries. A current ratio less than one may indicate a short-term liquidity problem as there are not enough current assets to meet the short-term obligations.
Days Cash on Hand = (Operating Expenses + Non-Cash Expenses) ÷ Number of Days in Period
This metric indicates the number of days that a business can continue to pay its operating expenses without generating any revenue. It is useful to measure risk for a startup operation, or for a business that relies on one or two large customers. It may also be useful in analyzing the risk of a sudden closure from an event, for example from a safety incident or a shut down by a regulatory authority.
Debt to Equity Ratio = Total Liabilities ÷ Equity
This ratio provides information about how a business is financed. Debt must be repaid with interest, so a high debt to equity ratio could mean the company is over leveraged and at financial risk of not being able to meet its debt payment obligations. However, debt has a role in any financing strategy and has the benefit that interest expense is tax deductible. If debt is too low, it may put the company at risk of a leveraged buy-out. Also, sometimes debt may be the only available option to finance growth. The debt to equity ratio can also be calculated using just long-term and short-term debt in the numerator instead of total liabilities.
Interest Coverage Ratio = Net Income before Interest and Taxes ÷ Interest Expense
This ratio provides an indication of whether business earnings are sufficient to cover the interest payments on debt. A higher ratio is correlated with stronger financial health.
Inventory Turnover Days = (Average Inventory ÷ Cost of Goods Sold) x Number of Days in Period
This ratio measures the average number of days that an item stays in inventory, from when it was purchased or produced to when it was sold. Inventory has a carrying cost and a risk of obsolescence, so a fast turnover rate with lower inventory days is more desirable.
Receivable Days = (Average Accounts Receivable ÷ Sales Revenue) x Number of Days in Period
This ratio measures the average number of days that it takes a customer with credit terms to pay an invoice. It can be calculated for an individual customer or for the entire business. A company wants to collect its money as fast as possible, so a lower number of receivable days is preferable. Analyzing the actual receivable days with the expected days can highlight problems with customer’s credit, or invoicing and collection procedures. For example, if receivables are calculated at 45 days for a customer with 30-day credit terms this may indicate a problem that needs to be investigated.
Payable Days = (Average Accounts Payable ÷ Cost of Goods Sold) x Number of Days in Period
This ratio measures the average number of days that it takes a business on credit terms to pay its bills to suppliers. It can be calculated for an individual supplier or for the entire business. A company should pay its bills on time to avoid issues with its suppliers. The calculated payable days should equal the expected days for payment based on the credit terms offered to the business.
These are just some of the metrics that can be helpful to business owners. Contact your accounting professional if you need help calculating or interpreting these ratios or developing other key performance indicators.
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