B2B CFO^®    (877) 4-B2B CFO

Financial statements are created to give business owners and stakeholders insight into the financial condition of their business. Performance measurements and ratio analysis help us analyze financial statements and identify financial trends in the business.  Ratios also allow you to compare your company's current data to the company's historic financial performance, financial goals as well as other companies' results. They are typically expressed as a percentage, multiple, or a dollar amount.
 
Often dashboard reports include performance measurements and other key performance indicators, giving management a convenient snapshot of  critical business data and trends without having to dig through the financial statements.  Performance measurements and ratios analysis fall into four main categories:
Liquidity ratios- the company's ability to meet its financial obligations
Profitability ratios- ability to generate earnings as compared to   
   expenses and other costs
 Leverage ratios- measures the use of debt in financing the 
   company's operations and assets
 Efficiency ratios- operational measurements on the quality of assets, 
     liabilities, and cost control
 
It would be burdensome to review dozens of performance measurements on a monthly or quarterly basis. It is therefore important to decide which performance measurements are most meaningful to your particular business. It is critical that the ratios are calculated on a consistent basis and there is agreement among the business managers that the correct data is being used in performing the calculations.  Below is a sample of two ratios in each of the above categories. 
   
Liquidly ratios
Acid Test or Quick Ratio=(Current Assets - Inventory) /Current Liabilities
This is a measurement of the liquidity position of the business.  It measures a   
company's    ability to meet short term obligations in an emergency situation.   
Inventories are removed from current assets     since it is unlikely that inventory will be 
able to be sold for full value in a short amount of time.  A ratio of 1:1 is considered        
satisfactory unless a majority of your assets are in accounts receivable and the timing 
of their collections lag the timing of your payment of accounts payable.
 
Net Working Capital = Total Current Assets - Total Current Liabilities
This is more a measure of cash flow than a ratio.  The results of this calculation 
should be positive.  Bankers look at Net Working Capital over time to determine a 
company's ability to weather a financial crisis.  Loans are often tied to minimum 
working capital requirements.
       
 Profitability ratios
Return on Investment (ROI)  = Net Profit before tax / Equity   
          (note: some analyst include long term debt with equity for this calculation)
ROI calculates the percentage return from your business on the funds invested.  The result of this calculation can be compared to alternative risk free investment (i.e. CDs, bank savings account, Treasury Bills).  Business owners want to make sure they are receiving a sufficient premium over a risk free investments to justify the risks and effort they are making in operating their business.

Breakeven Sales=Total Operating Expense/ Avg. Gross Margin %
This is an important measurement that calculates the sales necessary to realize a breakeven bottom line.  The calculation reflects how a decision to add fixed costs or changes to the gross margin percent impacts the sales volume that yields zero profit.

Leverage Ratios
Capitalization Ratio=Long Term Debt / (Equity + Long Term Debt)
The Capitalization Ratio measures the percentage of the company's capital structure that is supported by debt versus owners' capital.  Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.
 
Fixed Charge Coverage  = (Earnings before Interest & Taxes + Lease   
                                                payment) / Fixed Costs
This multiple indicates the number of times a firm's operating income exceeds its fixed payments. Fixed Charge Coverage is a measure of a firm's ability to meet contractually fixed payments. A high coverage ratio indicates significant flexibility for making payments in the event that business conditions deteriorate and earnings decline. Payments used in calculating fixed costs usually include interest, lease payments, preferred dividends, and principal payments on debt.  

Efficiency ratios
Sales to Working Capital Ratio = Annualized Net Sales/(Accts.  Receivable 
                                                             + Inventory - Accounts. Payable) This ratio measures the cash investment required to maintain a certain level of sales volume.   It is useful to track this ratio over time, enabling management to measure how changes in working capital policies impact sales.  These policies can include increasing or decreasing inventory levels and customer credit extension policies.  This ratio can also be useful for budgeting purposes, giving management an indication of future cash requirements at certain assumed sales levels.
 
Accts. Receivalbe Turnover Ratio =Annualized Credit Sales/Avg. Accts. Rec.
This is the ratio of the number of times that accounts receivable are collected throughout the year.  As with other ratios, tracking the results over time may highlight changes taking place in the business or general economy. A high ratio may indicate a credit policy that is too tight.  A low or declining ratio could be an indication of a collection problem, potentially resulting in bad debt write-offs.
 
Understanding and using performance measures not only help you better understand your business, they give you insight into how other financial professionals evaluate your business.