Sagacious Think

Most of the times, start ups are heads down, focused on what they need to do to keep afloat and make it to that next milestone.  Every so often its good to come up for air and take stock of how you are doing compared to your competition, and your industry in general.  One way to do this is to review your numbers, er ratios.  Sometimes just looking at the numbers themselves is overwhelming and they may not provide any context.  Ratios are a good way to get some context -not only for how you company is doing on its own but comparing it to industry averages.  A bit of research should provide you some good ratios to use as benchmarks. [Yahoo Finance is a good place to start.] If you are working with a banker or other investor they may offer some that they use.  Chances are they are measuring you against these averages so you should know how you are doing against these numbers.

Here’s a list of common ratios, that you as a business owner should be familiar with:

One point to remember is that this is a snapshot look at a company – and it too is can be missing some context.  All these ratios could change depending on the timing of cash flowing in or out; these ratios are not static.

Liquidity Ratios

current ratio – determines of a company has enough resources to pay its debts over the next year.  current ratio = current assets/current liability.  An acceptable ratio is generally 2:1 (the firm has twice the assets as debt).  As with everything exceptions exist – if you have a product that turns over faster than expenses are due, than a lower ratio is acceptable.

acid test ratio (AKA quick test, liquid ratio) – this number shows a firms ability to retire its current liability.  A good general ratio would be 1:1, but again this varies by industry, so it is important to understand what to measure against.   This number is (cash and cash equivalent + marketable securities + accounts receivable)/current liabilities

cash ratio – measures the ratio of  cash and cash equivalents against current liabilities.  This ratio is the most conservative of the ratios as it is a way to show how capable the company is of paying its debts without relying on the sale of inventory or receipt of accounts receivables.

cash conversion cycle (CCC) – Measures how long a firm will be short of cash if it elects to increase its investment in resources to expand customer sales

Profitability Ratios

profit margin analysis – determines what portion of the sales contributes to the income of a company and is the net income/revenue, or put another way its.  A low profit margin may indicate a pricing strategy

effective tax rate -alerts management to the tax rate the company faces (Income Tax Expenses/Pre-Tax Income).  This number most likely will not be the final number, due to various accounting factors, but it is a good indicator

return on assets ROA – measures a company’s profitability as a percentage of its total assets (net income/total assets ) x 100.  Also called return on investment.  Again, when these calculations are made has an impact.  Some businesses are cyclical so their ratios can fluctuate dramatically.

return on equity (ROE) – measures the rate of return on the ownership interest (shareholder’s equity) – This ratio is (net income after tax/shareholder equity)

return on capital employed (ROCE) – indicates the efficiency and profitability of a company’s capital investment.  The ratio is: EBIT/(total assets – current liabilities)

Debt Ratios

Debt-Equity Ratio (D/E) may also be called risk, gearing or leverage – indicates the relative portion of shareholder’s equity and debt used to finance a company’s assets.  The ratio is liability/equity

Capitalization Ratio – shows the proportion of the company’s debt to total capital.  Its a good way to peek at a company’s solvency.

Interest Coverage Ratio – indicates how well a company can meet its interest payment obligations.  The ratio is (EBIT/Interest Expense). If the number is less than 1, that means trouble, conversely if it is too high than is the company missing opportunities to invest through leverage?

Cash Flow to Debt Ratio – looks at the company’s operating cash flow to determine if it has the ability to cover its debt.  Care must be taken to understand what debt: short term, long term, or both.  Like all the ratios, there are nuances that must be understood for this ratio to have meaning and value.  A look at multiple ratios accounting for the different types of debt might be in order.

Operations Performance Ratios

Fixed Asset Turnover (FAT) – this ratio tells how well a company uses its fixed assets to generate sales.  A high ratio is generally better as it shows that a company does not have as much money tied up in fixed assets for revenue.  FAT = sales/ave net fixed assets

Sales/Revenue per Employee – show the average revenue generated per employee, and indicates how efficient a company uses its employees.  Growing and start up companies will show lower ratios, but industry averages will help determine the targets.  A good read on this topic, and here’s another.  CNN Money magazine even does a comparison.

Operating Cycle - This number is the average time from purchasing inventory to receiving payment.  The sam caveat applies, every industry is different, and all circumstances are different so its important to understand what factors drive your number.

Once a company has gone public there’s a host of other ratios to consider such as price/earnings ratio; price/earnings to growth ratio, dividend to payout ratio but I’ll leave that as a topic for another day.  Also, remember that these ratios are tools, just tools that can help management make decisions.  Understanding what they say is important, as is understanding how your company differs agains your industry norms and those of your competitors.  If you do not understand them or how to develop them for your business, consultants like myself can help.  If you have a finance person on staff, chances are they already have these numbers prepared, and they should walk you through what these ratios mean for your company.

Keep in mind, this list is not inclusive; dozens of ratios exist, and some might be more relevant to your business.  The goal of this post was to get you thinking about the power of ratios as a tool.