What are financial ratios?
This is part of an article we were asked to write, so we’re sharing the meat and potatoes. Ratios can be confusing and everyone wants to know what to do with them — here is a summary. (We’ll follow up with what levers to pull to move these ratios in a later article.)
What are financial ratios?
In simple terms a financial ratio is the comparison of one number to another number (on the financial statements) in order to judge performance over time. Common financial ratios measure such items as liquidity (the ability to generate cash to pay debt), profitability (gross margin), and investment performance (return on equity).
Who uses them?
Financial ratios give users of financial statements the ability to judge how well a company is performing based on a common set of calculations. This allows internal users (management) and outside parties (the bank or bonding company) to speak the same language regarding a company’s financial performance.
Why should I care?
You need the ability to read your business’s performance over time to spot trends and judge the health of your business. For example, a slowdown in cash collections will show up as an increase in Days Sales Outstanding, meaning it is time to start working the past due accounts or follow up on that retention that never got collected. Comparing gross margin of a particular department or division will allow you to determine what projects, services, or managers are contributing the most to the profitability of your business and if they are meeting their estimated profit on the bid or quote.
How do I measure ratios?
Measuring ratios is straightforward and we’ve included the definitions of several common ratios and the associated formula. You can track them on a simple dashboard, such as in Excel, as part of your monthly financial statement package. A lot of software packages have built in dashboards that show various measures of your business performance. The important thing is to start accumulating history, so you have the ability to look at trends over time and compare your current performance to expectations, past performance and peers in your trade.
How do I use them to make decisions?
Ratios can be compared to internal and external data to judge your business performance against both your history and the performance of your peers. Look for ratios where you are better than your past history (or your peers if using outside data). Consider what you are doing better than in the past and write down three to five things that you think are making the difference. These can then be discussed with your managers so everyone involved can continue to replicate the performance. Likewise, look for ratios where you are underperforming and determine what changes can be made to improve performance. Tracking the ratios on a regular basis (i.e., monthly or quarterly) will allow you to see if performance is continuing or if changes are generating the results you expected.
Which ones are important to me?
Here are several common ratios and definitions. You can track two or three to start with. Once you get a feel for the components of those ratios and get comfortable reading the data on a regular basis you can add more or different ratios. Think of it as a scorecard to see the health of areas of your business that are most important.
Current Ratio =Current Assets /Current Liabilities
A measure of short term liquidity. The ability to pay short term debt as it becomes due. A number above 1 is desirable.
Quick Ratio = (Cash + Net Receivables) /Current Liabilities
A measure of a company’s short term liquidity using only cash & A/R (items that can quickly be converted to cash). A number above 1 is best.
Days of Cash = (Cash * 360 days) / Total Revenue
A measure of how many days it takes to deplete a company’s cash. The more days on hand the less risk of meeting current obligations should collection of A/R slip.
Working Capital Turnover = Total Revenue / (Current Assets – Current Liabilities)
A measures of the ability to use working capital to generate sales. A higher ratio is better. A low ratio may mean A/R and inventory are turning too low leading to bad debts and obsolete inventory.
Return on Assets = Net Earnings / Total Assets
Measures a company’s ability to use it assets efficiently. A higher ratio and thus a higher return is better.
Return on Equity = Net Earnings / Total Net Worth
Measures the amount of return earned by the owner’s investment in a business.
Debt to Equity = Total Liabilities / Total Net Worth
Measures the degree to which assets are financed by debt. Lower ratios are preferred. A higher ratio may mean a business relies more on external lenders to finance operations and may have higher risk.
Revenue on Equity = Total Revenue / Total Net Worth
Asset Turnover= Total Revenue / Total Assets
Measures how well a company is using its assets to generate revenue
Under billings to Equity = (Unbilled work + Costs in Excess of Billings (Under billings)) /Total Net Worth
The percentage of a company’s net worth tied up in work performed but not yet billed.
Average Backlog to Working Capital = Backlog / Working Capital
How much accumulated, committed work a company has in relation to working capital.
Average Months in Backlog = Backlog / (Total Revenue / 12)
Average duration of work under contract.
Days in Accounts Receivable = ((Contract Receivables + Other Receivables + Allowance for Doubtful Accounts)) * 360 days) / Total Revenue
Average number of days to collect an A/R invoice from a customer (turn an invoice into cash). The lower the number the faster cash is collected.
Days in Inventory = (Inventories * 360 days) / Cost Of Goods Sold-Material
Average number of days to turn inventory. The faster inventory turns the less chance for obsolete inventory sitting on a shelf.
Days in Accounts Payable = ((Payables * 360 days) / Cost Of Goods Sold (net of labor/burden)
The average number of days to pay an A/P invoice. If A/P turns significantly faster than A/R you may be missing an opportunity for improved cash management and requiring the use of a Line of Credit to cover cash while you wait for your customers to pay you.
Operating Cycle = Days in Cash + Days In Accounts Receiveable + Days in Inventory – Days in Accounts Payable
Measures how quickly a company converts its “deliverable” into cash thru sales. The lower the number the more quickly cash is generated.
After you accumulate enough historical data and become familiar with looking at ratios you will be able to judge your performance on a regular basis and tell at a glance how your business is doing. Measuring performance is the best way to manage your business. Using ratios properly can help you do just that.
Now it’s time for you to pick two or three ratios and see how you measure up!
For more information talk to your banker or bonding agent to see what ratios they track or what some common statistics are for your trade. Also see our sections regarding banking and bonding relationships to learn more.