By themselves, financial statements tell you quite a bit…like, how much profit the company made, where it spent its money, how large its debts are. But how do you interpret all the numbers these statements provide? Is the level of debt healthy or not?
If you’re looking to assess the health of your company & identify opportunities for improvement, take a look at your financial ratios to see how the company compares to the industry. These can be useful indicators of how well your company is performing in a number of financial areas.
Ratio analysis allows you to dig into the information contained in the three financial statements. A financial ratio is just two key numbers expressed in relation to each other. Using ratios, you can benchmark your company’s performance to that of its competitors, to industry averages, & to its own performance in the past. Managers should use ratio analysis to pinpoint strengths & weaknesses from which SMART goals/plans can be formed.
This chart shows how some of the financial ratios are calculated. I used this as a guide for the different companies I started…I placed the industry averages by the ratio formula as a reminder when reviewing my company financials because one of the advantages of ratio analysis is that it allows comparison across companies, an activity which is often called benchmarking.
For example, using the data from the Income Statement: The Gross Profit is found by subtracting COGS from the Sales Revenue. If you divide this outcome by the Sales Revenue, you get the Gross Profit Margin that can be used to benchmark your company to that of your industry & competition.
Here is an example using Balance Sheet data: The CURRENT RATIO is computed by dividing current assets by current liabilities & is then expressed in mathematical terms. Working capital, by contrast, is expressed as an absolute dollar amount. Both concepts are measurements using the same components of a balance sheet.
By the way, there is a mathematical oddity that occurs when comparing working capital & the current ratio. One can improve the current ratio without changing the working capital. You must be very careful in interpreting financial ratios…this topic will be covered during video session 3 of this series.
The OPERATING PROFIT MARGIN is another example of how ratios can help you identify ways to help your company. Operating Profit Margin = (Sales – COGS – Operating Expenses – Depreciation & Amortization)/Net Sales.
Operating Profit Margin differs from Net Profit Margin as a measure of a company’s ability to be profitable. The difference is that the former is based solely on its operations by excluding the financing cost of interest payments and taxes. As a general rule, the higher the operating profit margin the better it is for the company since it denotes that the company has plenty of cushion to meet its fixed obligations like mortgages, business loans etc.
An operating profit margin that is higher than your completion means that you will be able to ride out the slower economic times much better than the competition since you have more cushion to operate under & still pay your fixed obligations like loans & obligations.
The OPERATING RATIO shows the efficiency of a company’s management by comparing the total operating expense of a company to net sales. An operating ratio that is decreasing is viewed as a positive sign, as it indicates that operating expenses are becoming an increasingly smaller percentage of net sales. A limitation of the operating ratio is that it doesn’t include debt.
RETURN ON ASSETS (ROA) indicates how well a company is using its assets to generate profit. It’s a good measure for comparing companies of different sizes. It is a relative measure of meeting the business goal.
The goal of any company is to make money if it wants to be sustainable. This goal requires managers to understand accounting concepts…not how to do detail accounting like “T” accounts but how the financial concepts measure business success. Every good manager must critically think using these concepts. A proven way to do this is by using ratio analysis & benchmarking.
If you enjoyed this thought, you might like the free video entitled The Financials – Managing Your Business Session 2 Financial Concept Uses and read a free sample of the new book “Small Business Thoughts Real-Time Strategic Planning“.
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