The Power of Financial Ratios

Ratios indicate the relationship of one number to another. People use them every day. A football player’s scoring rate per matches played, that is, how many goals scored for a given number of games. The odds of winning a lottery jackpot, say one in 6 million, show the relationship between winning tickets sold (1) and total tickets sold (6 million). Ratios don’t require any complex calculations. To figure a ratio, usually, you just divide one number by another and then express the result as a decimal or as a percentage.

All kinds of people use all kinds of financial ratios in assessing a business. For example:

·       Bankers and other lenders examine ratios such as debt-to-equity, which gives them an idea of whether a company will be able to pay back a loan.

·       Senior managers watch ratios such as gross margin, which helps them be aware of rising costs or inappropriate discounting.

·       Credit managers assess potential customers’ financial health by inspecting the quick ratio, which gives them an indication of the customer’s supply of ready cash compared with its current liabilities.

·       Potential and current shareholders look at ratios such as price-to-earnings, which help them decide whether a company is valued high or low by comparison with other stock (and with its own value in previous years).

The ability to calculate them – to read between the lines of the financials, so to speak – is a mark of financial intelligence. Learning about ratios will give you a host of intelligent questions to ask your boss or CFO. And, of course, I’ll show you how to use them to boost your company’s performance.

The power of ratios lies in the fact that the numbers in the financial statements by themselves don’t reveal the whole story. Is net profit of $10 million a healthy bottom line for a company? Who Knows? It depends on the size of the company, on what net profit was last year, on how much net profit was expected to be this year, and on many other variables. If you ask whether a $10 million profit is good or bad, the only possible answer is the one given by the woman in the old joke. Asked how her husband was, she replied, “Compared to what?”

Ratios offer points of comparison and thus tell you more than the raw numbers alone. Profit, for example, can be compared with sales, or with total assets, or with the amount of equity shareholders have invested in the company. A different ratio expresses each relationship, and each gives you a way of gauging whether a $10 million profit is good news or bad news. As we’ll see, many of the different line items on the financials are incorporated into ratios. Those ratios help you understand whether the numbers you’re looking at are favourable or unfavourable.

What’s more, the ratios themselves can be compared. For instance:

·       You can compare ratios with themselves over time. Is profit relative to sales up or down this year? This level of analysis can reveal some powerful trend lines – and some big warning flags if the ratios are headed in the wrong direction.

·       You can also compare ratios with what was projected. To pick just one of the ratios we’ll be examining in this part, if your inventory turnover is worse than you expected it to be, you need to find out why.

·       You can compare ratios with industry averages. If you find that your company’s key ratios are worse than those of your competitors, you definitely want to figure out the reason. To be sure, not all the ratio results we discuss will be similar from one company to another, even in the same industry. For most, there’s a reasonable range. It’s when the ratios get outside of that range, as Sunbeam’s DSO did, that its worth your attention.

There are four categories of ratios that managers and other stakeholders in a business typically use to analyse the company’s performance: profitability, leverage, liquidity, and efficiency. I will give you examples in each category. Note, however, that many of these formulas can be tinkered with by the financial folks to address specific approaches or concerns. Tinkering of this sort doesn’t mean that anyone is cooking the books, only that they are using their expertise to obtain the most useful information for particular situations (yes, there is art even in formulas). What I will provide are the foundational formulas, the ones you need to learn first. Each provides a different view – like looking into a house through windows on all sides.