Ratios in financial statements

If a banker looks at the ratios in a set of financial statements to determine the health of a business, shouldn’t the management look at the same information?

Management should be looking at ratios to determine operational issues as well as any issue that would affect the businesses’ credit standing. When reviewing your financial statements, regularly consider the critical ratios and the related trends. Some ratios that apply to most businesses are:

• • Current ratio
    Formula: Current assets / current liabilities
    This is a very good indication of the liquidity of the business and its ability to pay its operating obligations without incurring additional debt.

• • Quick ratio
    Formula: Current assets – inventory / current liabilities
    As inventory can take longer to convert into cash, it is excluded from the formula to ascertain if there is enough liquidity to pay its operating obligations, without incurring additional debt or waiting for a business cycle to pass.

• • Gross margin percentage
    Formula: Gross profit / sales
    This is probably the most critical ratio for a business that sells goods. The regular, detailed analysis of causes of fluctuations is critical to ensuring operational efficiency.

• • Expenses, in major categories, as a percentage of sales
    Formula: Total expenses in a category (e.g. administration) / sales
    Fluctuations should be analyzed to ascertain if there is a problem that has caused the expenses to rise, or an opportunity revealed by a decrease in the ratio.

• • Debt to equity ratio
    Formula: Total liabilities / total equity
    Essentially this is a measure of business risk based on its exposure to debt and interest on the debt. Of course, the type of debt is also a significant factor as debt that is repayable on demand (e.g. a line of credit) is a much greater exposure than term debt. A variation on this formula only includes interest bearing debt instead of total liabilities and I recommend that you monitor both if you do have a significant debt exposure.

• • Days receivables outstanding
    Formula: Total accounts receivable for sales (i.e. exclude receivables that are not from customers, such as HST input tax credits) at the period end / total sales for the period (including any taxes, as these are included in the accounts receivable amount) x number of days in the period.
    Ratios are the only way to measure the overall collections as sales fluctuate, and the period outstanding changes for different customers

• • Days inventory on hand
    Formula: Total inventory at the period end / total cost of sales for the period x number of days in the period.
    As inventory levels and values fluctuate, this is the best way to measure the overall inventory management. Even more effective is to measure the day’s inventory on hand for each major category of inventory.

Many executives do not focus on their ratios because they are not sure what the “correct” ratio is for their business. Do not worry about the absolute value – there is no “correct” ratio and the trend is much more important than the comparison to other businesses. Of course, regular monitoring of any ratios that your bank or other lending institution requires is essential. Ensure that you alert them to upcoming material changes, especially adverse ones, along with a detailed explanation that includes your plans to manage the situation

The value of using ratios is their ability to reflect trends in your business that are not easy to spot. If you track your ratios on a periodic (monthly, or at least quarterly) basis, you should be able to explain in simple words why a ratio has changed and what you propose to do to manage the situation, for better or worse.

To utilize ratios most effectively, one should always compare current period-end ratios to those for the same period in the previous year and also those in the budget. For most businesses it is adequate to measure your ratios at each month-end. More frequent calculation can be overkill, unless there is a critical need. However, a “dashboard” reflecting the ratios that were in effect at the previous month-end is a great way to keep them “top of mind” for your management team. Of course, that means that the team responsible for managing the business should be constantly aware of the ratios and their significance.

For example, the days receivables outstanding and days inventory on hand are often very helpful warnings about cash flow problems and are often the first sign that more analysis and focus is required.

One word of caution in closing: Be careful not to assume that a change in a ratio is attributable to the event that you are aware of. It is quite possible that there are two or more events that are causing the change in the ratio. An example of this is where the gross margin drops by say 4% and you are aware of a large customer return in that month. The easy conclusion is to assume that the entire 4% is attributable to that return. Ensure that you ask your Controller to do the math and ensure that the return has caused the entire 4% drop. I have often found that this exercise shows that the return is only responsible for a part of the drop in margin percentage, and that there is further analysis required to find the other causes.

About the Author
James Phillipson is a Chartered Accountant and a Principal of Mastermind Solutions Inc. with over twenty years experience in large and small businesses. He has provided financial counselling to his clients since 1996, often in the role of a Controller or Chief Financial Officer. James has experience in financial roles in a wide variety of businesses and industries.

If you have any questions feel free to contact james@mastermindsolutions.ca or (416) 726-8256

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