Financial Ratios & Other Financial Analysis Tools
Here is a list of many ratios used to analyze a company's financial condition - along with an explanation of why they are considered to be important.
- Current Ratio
- Acid Test Ratio
- Average Collection Period
- Times Interest Earned
- Net Income + Non-cash Exp /
Current Portion of LT Debt
- Fixed Assets / Tangible Net Worth
- Debt to Tangible Net Worth
Operating Ratios and Indicators
- Gross Profit Margin
- EBT / Tangible Net Worth
- EBT / Total Assets
- Fixed Asset Turnover Ratio
- Total Asset Turnover Ratio
- E.B.I.T.D.A. ("Ebitda")
Expense to Revenue Ratios
- % Depreciation, Depletion & Amortization / Revenue
- Officers' &/or Owner's Compensation / Revenue
- Altman's Z-Score for Privately Held Firms
Banks often use ratios in loan contracts with benchmarked minimums or maximums (aka 'Covenants').
Even if covenants are not listed in your loan contract, banks still look at them.
You will add credibility to your financial statements if you include financial ratios and indicators in your
presentation to the bank. They will think you use these indicators internally, and they'll love you for it!
Actually; If you're not using Financial Analysis Tools and Benchmarks internally, you should strongly consider it.
Liquidity ratios indicate the company’s ability to meet its short term obligations.
- The Current Ratio is calculated by dividing current assets by current liabilities. If current assets are greater than current liabilities,
the current ratio will be greater than 1.0.
- The Acid Test Ratio compares Current Liabilities to Current Assets that can be quickly converted to cash. Here is an example of a
formula for an acid test ratio:
Cash + Cash Equivalents + Short-Term (liquid) investments + Accounts Receivable
A ratio of 1.0 or higher is generally consider to be a good score, but this is relative to the industry your company is in.
- Average Collection Period: This is an estimate of how many days it takes the Company to collect Accounts Receivable. This is
literally the Revenue/Accounts Receivable ratio restated in terms of days.
If Annual Sales / AR = 4, then the the Average Collection Period is
90 days (360 / 4 = 90).
This ratio can indicate the Companies efficiency in making collections
and/or its customer satisfaction (among other things) when it is compared to industry standards.
The Average Collection Period and Revenue/Accounts Receivable are also considered to be Activity Ratios. Other activity ratios include
Inventory Turnover (or COGS / Inventory), Payables Turnover, and Revenue/Working Capital.
Coverage Ratios measure the Company’s ability to meet certain obligations and/or the Company’s ability to generate earnings over and above certain
expenses or fixed costs.
- Times Interest Earned: Also called the Interest Coverage ratio. The formula to calculate Times Interest Earned is:
Net Income divided by Interest Expense.
- Net Income + Non-cash Expenditures / Current Portion of Long-term Debt: This ratio measures the Company’s ability to pay its short-term
debt with cash generated from Operations.
IE: ‘Net Income + Non-cash Expenditures’ is a good estimate of how much cash was generated from Operating Activities.
Leverage ratios attempt to measure either the effectiveness or the extent of a Company’s use of certain assets, liabilities or investments. Leverage
ratios vary greatly from one industry to another, so they are more effectively understood when compared to industry standards.
- Fixed Assets / Tangible Net Worth: Comparing the Company’s Tangible net worth (equity less intangible assets) to the book value of fixed
assets will indicate if the Company is heavily invested in fixed assets. Falling below industry standards could indicate that the company needs
to upgrade its equipment, or that the Company re-invests a higher level of earnings than other Companies in the industry.
- Debt to Tangible Net Worth: Also known as Debt-to-Equity in many cases: A High debt to equity ratio may indicate that the company
is having a hard time meeting its obligations.
OPERATING RATIOS and INDICATORS
Operating ratios typically focus attention on some aspect of Earnings or Sales in order to draw a conclusion about the Company’s ability to generate income.
- Gross Profit Margin: Sales - Cost of Goods Sold / Sales. This ratio measures what percentage of each sale is applied toward Gross
In theory; The Gross Profit Margin expresses the portion of marginal sales that will be added to net income before taxes, after
the Company has generated enough sales to cover fixed costs and overhead. To measure the companies true profit margin, you would have to isolate
ALL variable costs - not just Cost of Goods Sold. In addition, some COGS may be fixed in nature.
- EBT/Tangible Net Worth: Earnings Before Taxes over Tangible Net Worth. This Ratio measures the Pre-tax earnings as a percentage
of how much shareholders have invested in the Company. Publicly traded companies more often use Return on Equity and Earnings per share to
express this concept.
- EBT/Total Assets: This Ratio measures pretax earnings in comparison to total assets.
- Fixed Asset turnover ratio: Sales / Fixed Assets. This ratio provides a multiple that can be compared to industry standards
to measure how much Sales are being generated in relation to the Company’s investment in Fixed assets.
- Total Asset Turnover ratio: Sales / Total Assets. This ratio is similar, in concept, to the Fixed Asset Turnover Ratio, except
Total Assets are used as a comparison.
- E.B.I.T.D.A.: Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
This is supposed to measure the companies ability to generate cash-flow to pay it's obligations. I think banks like this indicator because it's
fun to say "EBITDA".
Go ahead, say it. "EBITDA" That was fun, wasn't it?!
EXPENSE TO REVENUE RATIOS
Expense to Revenue Ratios are also referred to as Common-Size Analysis. Expenses are expressed as a percentage of total sales. Common-Size Analysis
is a very common tool used to compare a company’s activity with prior year activity, with other companies, and with industry averages.
- % Depreciation, Depletion, and Amortization / Revenue: This measures the typical non-cash expense items to total sales.
- Officer’s &/or Owner’s Compensation / Revenue: This is a very important item to note for privately held company’s because; this
Percentage can vary widely from one company to another; and it directly effects Net Income. IE: If Officer’s Compensation is 35% of Sales
and Net Income was at a 2% loss, it may be wrong to assume that the Company is not profitable.
Lenders and financial analyst will often select a list of ratios and assign a relative point value to each one. This is done to attempt an objective
assessment of a particular company. One of my favorite analytical tools of this type is the Altman's Z-score for Privately Held Firms - A variation of
the original Z-score formula developed by Dr. Edward I. Altman in 1968.
ALTMAN'S Z-SCORE for Privately Held Firms: This series of ratios is used to predict a bankruptcy up to 2 years before it happens.
This widely accepted tool adds the results of 5 financial ratios. The resulting total is used to to assess the company's financial viability
as a going concern:
- Working Capital / Total Assets.
- Retained Earnings / Total Assets.
- Earnings Before Interest and Taxes / Total Assets.
- Market Value of Equity / Book value of Total Debt. This is not a readily available number for privately held companies, so
I often use a
'rule of thumb' valuation to calculate the Market Value of Equity.
- Net Sales / Total Assets.
Ad the results of these 5 ratios together. The resulting total is then assessed based on a pre-determined scale, and based on the industry you are in:
Altman's Z for Private Firms - Predetermined Cut-offs:
||Less than 1.1
||Less than 1.23
||Less than 1.81
|Zone of Ignorance
||1.1 to 2.6
||1.23 to 2.9
||1.81 to 2.99
||Greater than 2.6
||Greater than 2.9
||Greater than 2.99
If your company is in the 'Zone of Ignorance', you should contact a CPA to discuss your options.
Here are some options you may consider:
The last suggestion was tongue-in-cheek of course, but it has happened in the past: Metatek, First Americable, Planet Hollywood, Baileys Plastics, etc..
- Right-size the company based on your current market share and an honest assesment of what the company is capable of in the future.
- Create a new business plan and seek an infusion of capital.
- Quietly sell the Company's assets, pay bonuses to your Senior Directors, and stick it to the minority shareholders by leaving them with nothing.