Have you ever looked at your company’s or organization’s financial statements and thought to yourself, “Okay, I see how much we earned this period. I also see a bunch of different numbers on several pages, so there must be more to this than net profit. How can I extract additional meaningful information that will help me run my business?”
Financial ratios are one of the tools used routinely by owners, managers, investors, and creditors to assess the financial health and performance of an enterprise. Using key ratios, you too can glean a wealth of information from your financial statements.
A ratio, simply defined, represents the relationship between two numbers, which numbers are generally extracted directly from the financial statements. For example, if your profit for the year was $200,000 and your sales for the year were $800,000, your net profit margin would be $200,000/$800,000, or 25%.
As I have often maintained (and always will), no single number, or ratio for that matter, is particularly meaningful in and of itself until you compare it to something else. Ratios are typically compared to: (1) the same ratio over different periods of time, (2) those of other companies in the same industry, or (3) average ratios in the industry. For example, your profit margin of 25% for this year takes on a whole new perspective if your profit margin for last year was 20%, or alternatively, 30%.
Ratios of privately-held companies and similar organizations are generally grouped into the following categories:
- Profitability ratios – measure various rates of return;
- Liquidity ratios – measure the availability of cash to fund operations and pay debt;
- Debt, or leverage ratios – measure the organization’s ability to repay long-term debt; and
- Activity, or efficiency ratios – measure how effectively an organization uses its resources.
The following are some of the more commonly used activity ratios:
Asset turnover ratio = revenues/total assets: represents the amount of revenues generated for each dollar invested in assets. The higher the ratio, the better.
Accounts receivable (A/R) turnover ratio = revenues/accounts receivable: represents how quickly an organization collects its accounts receivable (sales on credit to customers). Again, the higher the ratio, the better.
Days sales outstanding (DSO) ratio = Accounts receivable/(revenues divided by 365 days): represents the number of days of sales included in accounts receivable. In this case, the lower the number, the better.
The above ratios can best be explained using an example. Assume that an organization’s financial statements reflect the following information for a three-year period:
Using the formulas above, we calculate the following ratios:
Asset turnover: As indicated, the company generated 81 cents in revenues for every dollar invested in assets in 2007, vs. 75 cents for every dollar of assets in 2009. Despite the increase in revenues from $511,200 to $584,400, the company employed its assets slightly less efficiently in 2009, because it required a proportionately higher investment in assets to generate revenues during that year.
A/R turnover: Despite the increase in revenues between 2007 and 2009, the company was actually able to reduce its accounts receivable balance during the same period. Therefore, accounts receivable turnover increased from 3.9 times in 2007 to 4.4 times in 2009. This increase, which is desirable, indicates that the company collected (or “turned over”) its accounts receivable more quickly in 2009 than it did in 2007. Whenever collections of accounts receivable are accelerated, it benefits the organization in the form of improved cash flows – the sooner we can collect cash, the better.
DSO: Similarly, days sales outstanding decreased from 94.5 days in 2007 to 83.8 days in 2009. Simply stated, the company’s receivables were comprised of 94.5 days of revenue in 2007 vs. 83.8 days of revenue in 2009 – i.e. fewer days of uncollected credit sales to customers. This makes sense, given the increase in revenues, the corresponding decrease in accounts receivable, and the fact that the company collected its revenues 4.4 times in 2009 vs. 3.9 times in 2007. In fact, days sales outstanding can also be calculated by dividing the number of days in the year by A/R turnover (365/4.4 = 83 days).
Of course, ratio analysis is only the first step in analyzing and using financial information. The next step is to dig a little deeper in order to discern underlying causes and to determine if interventions are in order. To use a medical analogy, ratios can be compared to a patient’s symptoms. After observing the symptoms, the doctor’s next responsibility is to determine the diagnosis in order to prescribe the appropriate treatment plan.
