How to Understand Your Company Using These 4 Financial Ratio
Are you an investor or finance manager? Then you will need to understand how is your company doing from its financial statements. Maybe you can read your financial statements, but the numbers seem to have limited meaning for you. That is because you need to first convert them into financial ratio. Then you will see the magnitude of the numbers in your financial statements.
These are four financial ratio often used by anyone wanting to know the health of their company.
1st Financial Ratio: Profitability
The first thing one wants to see in a company is obviously how the company generate profit. The first ratio you want to know is how much profit generated from the sales. Then you should calculate Net Profit Margin = net profit : revenues
The higher the number, the better. It means that the company generates huge profit out of the existing sales. So if you can enlarge your market and boost your revenues, then you know you will multiply your profit.
If the net profit margin is not so high, then you should find the problem by breaking the number into Gross Profit Margin = gross profit : revenues And Operating Profit Margin = operating profit : revenues
If you see some inconsistencies in the numbers then you know there is something that you can fix in the area.
The second thing you want to see is how the asset of the company generate profit. Return on Asset can help you get the idea. Return on Asset = Net Income : Total Assets
If the number is too small, then you may have unproductive assets in your book. It may be overly large receivables or even cash. Cash is not generating comparable profit to your business. Bank deposit should deliver lower return to you, otherwise, get out of your investment and just deposit it to risk-free bank deposit.
Now, similar to Return on Asset is Return on Equity. This one gives you the idea on how your equity generate profit. Return on Equity = Net Income : Total Equity
There are other profitability ratios that you may learn along the way, but these are the more important ones.
2nd Financial Ratio: Liquidity
Liquidity ratio gauge a company's ability to pay off its short-term debt obligations and convert its assets to cash. The more liquid the company is, the higher the possibility it grows its investment. It is intuitive, because the more you have cash in you pocket without having to have paid something to your friend, you can buy more.
One common liquidity ratio is the current ratio. Current Ratio = Current Assets : Current Liquidities
The higher current ratio the better. It means your company has better ability to pay its short term debt.
Another liquidity ratio is Cash Ratio. Cash Ratio = Cash and Cash Equivalent : Current Liquidities
This is to magnify the ability to pay the company’s short term debt immediately. The higher current ratio the better. However, you should beware if the number is too high in an investment supportive environment. It is because cash is too much, and cash is not provide as much return as the company should have.
If you are comparing among peers, you should remember that different financing structure would give different liquidity ratio analysis.
3rd Financial Ratio: Solvency
If Liquidity Ratio gives you idea on how your company can pay its short-term liabilities, solvency gives the idea how it will pay all liabilities. Solvency can be an important measure of financial health especially in crisis situation. The higher debt you have the higher probability that you cannot afford it.
The easiest way to gauge solvency is to simply looking at its net assets. Net Assets = Assets – Liabilities
Many companies have negative shareholders’ equity. It is a clear and loud sign of insolvency. The company is not generating enough profit.
There is also another way to determine the company’s solvency. It is with Debt to Equity Ratio, usually shortened to DER. Debt to Equity Ratio = Debt : Equity
The number gives you the idea of the proportion of the debt as compared to equity. Generally, the higher the number, the riskier your company.
But level of solvency ratio is also determined by the industry your company is in. Some industries just usually have significantly higher solvency ratio than others. Airlines industry, for example, has higher DER than marketing company.
Another solvency ratio is Debt to EBITDA = Debt : EBITDA
EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization is a measure a company's overall financial performance. Investors usually use it because it is more stable over the years than net income.
Debt to EBITDA ratio gives the idea how many periods the company could pay its debt given the stable EBITDA over the years to come.
There are several solvency ratios that are derivative from the ones that we have learned. They are Debt to Assets = Debt : Total Assets or Total Assets to Equity = Total Assets : Equity
And many more.
4th Financial Ratio: Turnover
This type of ratio gives you the idea how fast your company move its assets. A deeper analysis could give solutions on how to improve efficiency in the company. Let’s take a look.
First one is Receivables Turnover = Revenues : average Receivables
This ratio is to give the idea how well your company uses and manages the credit it extends to customers. The higher the number means the credit is paid immediately. If the number is too low, you may face cash shortage in the future.
Second one is Payable Turnover = Cost of Sales : average Payables
Mirroring the receivables turnover, this ratio gives you the idea how you have optimized the credit you get from your suppliers. Usually the higher the number, however, the smaller power you have over your suppliers. If possible, you should try to lower your number. On the other hand you also need to beware that it may mean that you cannot pay them, which means at one point, they will stop extending credit to you.
Third one is Inventory Turnover = Cost of Sales : average Inventories
This gives you the big picture on how fast your inventories are sold. The higher the number means that your inventories are out of the stock fast. But this is very industry related. Obviously selling airplanes cannot be as fast as selling biscuits.
Compare Your Ratio Historically and to Company’s Peers
If you are not sure whether the number is good enough for your company, then you can compare it. Comparable analysis can be done over the history of the company itself. It can also be done by compare it to other companies in the similar industry.
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