By Nizam Shajani, CPA, CA, MBA
This information is taken from the CPA resources on Financial Literacy.
Understanding your financial statements is key to making good informed decisions. Shajani LLP offers reporting based on your financial ratios that will provide key advisory services that can be a competitive advantage to your business.
A common questions business owners ask are
- How profitable is my business?
- Ho do my profits compare to the industry?
- What’s the trend in my profits?
- How quickly are we growing?
- Can we pay the bills?
- Can we pay the bank?
- Am I getting a return on my investment?
Financial ratios are tools that can be used to systematically examine financial statements and facilitate an answer to these questions. A ratio is simply a tool by which one number can be compared to another. Ratios typically are better sources of comparison than simply eyeballing the raw numbers. Common ratios will help evaluate profitability, analyze trends, measure growth, evaluate borrowing capacity, and measure bill-paying ability.
Ratios can be thought of like the gauges in the dashboard on your car. They are tools telling you what’s happening to your car, or to your business. Your car might have a gas gauge, a temperature gauge, an oil pressure gauge, and a battery gauge. If anyone of these items goes out of the safe zone, such as the gas gauge going to zero, the temperature gauge going into the red zone, or the battery discharging, the car isn’t going to work. Likewise, if the ratios for your business are out of the proper zone, these provide an indication that there could be problems with the business.
Trends in ratios also provide information with respect to the health of the business and critically helps with forecasting and budgeting.
It it’s important to understand and measure the profitability of the company, and profitability ratios allow you to measure both profitability and the returns from a business. There are five key profitability ratios.
Gross margin is the ratio of the profit to sales. Gross margin measures the percentage profit a business makes on sales. The formula for gross margin is gross profit, which can be found on the profit & loss statement divided by revenue, which can also be found on the profit & loss statement.
Operating margin is the ratio of the profit to operations. The operating margin is a measure of the profitability of the business after operating expenses have been included. The formula for operating margin is similar to the formula for gross margin, except that the numerator is now operating profit, which is divided by revenue.
Net margin is the bottom line profit. Net margin is a measure of the overall profitability of the business after all expenses, interest payments, and taxes have been paid. The formula for net margin is net profit divided by revenue.
Gross margins, operating margins, and net margins vary based on the type of business, with customer centric businesses typically earning higher margins than operational centric businesses.
Return on assets is the profit (return) by assets used. Return on assets measures how efficiently assets were used by the business in order to generate profit. The formula for return on assets is net profit, which can be found on the profit and loss statement, divided by total assets, which we obtain from the balance sheet.
Return on equity is the profit (return) to the owners. Return on equity is a measure of the rate of return (i.e., net profit) as a percentage of shareholders’ (or owners’) equity. This is a key measure, which is often used to compare the results from the investment in this business to alternative investment opportunities. The formula for return on equity is net profit, divided by owners’ equity, which we obtain to the balance sheet.
Ratios allow the comparison of a business to industry benchmarks as well as to competitors. While it’s not always possible to obtain data for privately held competitors, there is often industry trade association data available for specific industries. An owner can compare his or her profitability to this trade association data. It’s also possible in many instances to compare returns to public companies in the same industry. At Shajani, we have access to private company ratio databases and can provide a detailed report at your request. Alternatively, data sources of competitive data include trade association databases, as well as University databases, and government census and commerce department databases. Public company information can be found on Sedar, where public companies file official documents electronically. Statistics Canada is also a good source for industry comparison.
Current ratio provides a measure of a business’s ability to pay its bills during the next year. The current ratio compares the dollar amount of the business’ current assets to the dollar amount of its current liabilities. The definition for current assets includes items such as cash, Accounts Receivable and inventory. The definition of current liabilities includes the bills that are due over the next year. Current liabilities typically include accounts payable, as well as loan principal payments and other payments that must be made over the next year.
The current ratio of 1.0 or more indicates an ability to pay upcoming bills. A current ratio of 1 indicates that the company has exactly enough current assets to offset current liabilities, which may not be an ideal situation from an operating perspective. Many lenders look for current ratios greater than 1.5.
Quick ratio is the same calculation as current ratio, without the inclusion of inventory. The formula for quick ratio is the current assets less inventory, divided by current liabilities.
The calculation of the current ratio assumed that inventory was a current asset that could be converted to cash within the next year. The other current assets, such as cash and Accounts Receivable are generally very liquid, but inventory must be sold to be converted to cash. The quick ratio provides a comparison of those assets that are already in cash or can quickly be converted to cash, such as Accounts Receivable, but not inventory, to the bills due during the next year.
In general, the higher the company’s quick ratio, the better, as it indicates strong liquidity. A quick ratio below 1 may indicate that the company will have difficulty in paying its upcoming bills.
When a banker evaluates the ability of a business to make its loan payments, the bankers often rely on an analysis of leverage ratios. Leverage ratios measure the overall debt level of a business as well as a business’s ability to repay existing and new loans. The key leverage ratios are the debt to equity ratio, interest coverage ratio, and the fixed payment coverage ratio.
Debt to equity measures the amount of debt and other liabilities in relation to the owners’ equity in the business. Banks look for low debt-to-equity ratios. The formula for the debt-to-equity ratio is total liabilities divided by owners’ equity.
Interest coverage measures the ability of a business to make its interest payments from its operating profits. The formula for the interest coverage ratio is operating profit divided by interest payments. When a banker underwrites a loan request, they typically will look at the interest coverage ratio with the existing debt, as well as the projected interest coverage ratio with the new loan in place. Bankers typically look for interest coverage ratios of at least 2.0.
Fixed payment coverage is also considered when making lending decisions. In addition to looking at a business’s ability to make interest payments, bankers often look at a business’s ability to make both its interest payments and its asset lease payments. The ratio used for this comparison is the fixed payment coverage ratio. The numerator of the fixed payment coverage ratio calculation is the operating profit of the business, plus the asset lease payments (the asset lease payments get added back in because they were deducted when operating profit was calculated), divided by the total fixed payments of the business-that is, interest, principal, and asset lease payments.
Considerations on growth rates, trend analysis and revenue and expense trends also provide insight into a company’s performance.
Shajani would be happy to discuss your financial ratios with you. We are also able to provide a more detailed reporting with analysis to support you in your decision making for the company. We can also provide advice on how to move your financial ratios to produce a stronger set of financial statements.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. © 2020 Shajani LLP