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Ratio Analysis For Dummies

Nov 23, 2009

Ratio analysis.  Sounds like a fascinating topic.  Something I really need to spend my time on.  Right.... 

Most business owners react the same way.  And no wonder.  Ratio analysis can be dry as dust, impenetrable, complex and confusing.  But it's also a really good way to perform an "Executive Physical" on your company.  If you don't want to read about all the ratios, you can see what 6 top B2B CFOs told Inc. Magazine about ratios, or you can call me now for a free ratio analysis of your company - no strings attached, and a look at some simple ways to track this information.  Make the call.  Your banker will thank you...

Inc. Magazine article on ratios for business, featuring six B2B CFOs on a variety of industry types: Inc Article

 

And for those who like to do it themselves, here are the top ratios you should be looking at:

 

RATIO HEAVEN:

Net Profit Margin

Net Pretax Profit ÷ Revenue

The bottom line -- the amount you have left after every other expense is taken out.  Varies with industry and over time, but should be at least 5%. Otherwise, you might just want to open a pass book savings account.

 


Gross Profit Margin

Gross Profit ÷ Revenue

Gross profit is your revenue minus what it costs to make your product.  Maximize this because you've got to make enough to cover the overhead - or you might as well close the doors.  You cannot make it up on the volume!


EBITDA Margin

EBITDA ÷ Revenue

Many companies use this as a shorthand measure of cash flow. EBITDA is earnings before interest, taxes, depreciation, and amortization.  You add back these items because they don't use cash and because they are so variable for each company  Thus EBITDA gives external analysts a better way to compare you with peer companies.


Return On Equity

Net Income ÷ Total Equity

The return your shareholders are getting on their investment.  Better be in the 15% plus range, or else why would investors take a risk with you?


Return On Assets

Net Income ÷ Total Assets

Net income generated for each dollar of assets. It's especially relevant for capital-intensive industries, like manufacturing.  Tells you whether that shiny new laser that everyone insisted you needed was worth it.


Interest Coverage Ratio

EBITDA ÷ Interest Expense

This ratio shows roughly how easily you can repay your debts.  Crucial ratio for a banker - they love it when it's 6.0 or higher.


Debt to Equity Ratio

Total Liabilities ÷ Total Equity

What you owe compared with what you own.  Also key for a banker who does not want to be the fall guy.  If you don't have much equity, the bank is exposed to higher risk.  Think of your house.


Inventory Days

(Inventory ÷ Cost of Goods Sold) x 365

The amount of time it takes to convert inventory into sales.  Varies by industry from 12 days in frozen foods to 45 days in manufacturing.  If it's more than 90 days your expensive "stuff" is gathering dust and losing value.


Accounts Payable Days

(Accounts Payable ÷ Cost of Goods Sold) x 365

The number of days, on average, you take to pay your bills.  Typically around 40 days, you want to take advantage of creditor terms without sendng messages that you can't pay bills.  Look at the trend.


Accounts Receivable Days

(Accounts Receivable ÷ Sales) x 365

The number of days, on average, your customers take to pay you.  Probably around 30 to 45 days depending on industry.  Break it out by aging buckets and pay close attention if the trend is up.


Current Ratio

Total Current Assets÷Total Current Liabilities

The amount of cash (or assets that can be turned into cash) on hand.  May be less in retail or in service companies, but 2:1 is viewed as good.


Quick Ratio

(Cash + Accounts Receivable) ÷ Total Current Liabilities

Similar to the current ratio, this is a good measure of a company's short-term cash position. Generally should be 1:1.

With all ratios, the only way to see the big picture is to develop a trending dashboard that allows you to quickly  review progress and highlight exceptions.  You can plan to improve, but ignorance will kill you. 

For a professional and complimentary review of your ratio perforamcne contact David Kirkup, Partner at B2B CFO on 404 348 0326 or dkirkup@b2bcfo.com.

 

 

More from David Kirkup…

About the Author

David has over two and a half decades of business experience and is a proven financial management expert. Working in Europe and the USA, David has served as Divisional CFO at a number of Fortune 500 corporations: including Reuters, Marsh & McClennan, Zurich Insurance and ADP as well as numerous small and mid size companies. As part owner of a small software company, he was heavily involved in the marketing efforts and ultimate sale of the company. As CFO with a national PEO firm he dealt with the credit and financial issues facing hundreds of small business clients. David also spent 5 years in Bermuda managing captive insurance companies.

View David’s Personal Website

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