BACK TO BASICS: 8 Ratios to Gauge Your Company’s Health
June 7, 2017 — What kind of shape is your company really in? Here are eight standard financial ratios that we look at first when evaluating the health of your company, both over time and within your industry.
1. The Current Ratio
Are your assets greater than your liabilities? It’s worth doing the math. Whether or not you have enough cash, accounts receivable, and inventory on hand to cover your short-term debts, payables, and taxes can be indicative of the health of your company. If your magic number drops below one, you may have trouble meeting obligations if the need arises. But a high current ratio isn’t necessarily better. If it’s too high, you may not be using your current assets as efficiently as you could be. The sweet spot varies from industry to industry, but, generally, if your current ratio lands between 1.5 and 2, the liquidity of your company is right where it should be.
2. The Quick Ratio
The quick ratio is another way to measure your company’s liquidity. Unlike the current ratio, the quick ratio only accounts for assets that can be liquidated quickly, like cash equivalents, short-term investments, and receivables. Assets that would take longer to turn into cash, like inventory, are left out, providing a conservative, but accurate barometer of the present strength of your company.
3. Inventory Turnover
One way to measure your company’s efficiency is to determine how often your inventory is sold and replaced over a set period of time. A low ratio of sales to inventory on hand could suggest either weak sales, excess inventory, or both. Either way, the longer your inventory sits on the shelves, the less it’s probably worth. Generally, a high inventory turnover ratio suggests you’re moving inventory well. But because this ratio is a measure of efficiency, it’s important to consider the alternative: maybe you’re not taking on enough. The healthy range for an inventory turnover ratio varies widely, and should be compared within others your own industry. We hope that a grocer, for example, would replace produce faster than a boat dealer sells yachts. To judge one against the other would be like comparing apples and, well, yachts.
4. Average Collection Period
You can measure the strength of your company’s cash flow, another indicator of efficiency, by determining the time it takes to collect accounts receivable from your clients. Here a lower ratio suggests clients are paying receivables quickly, meaning your company will have enough cash on hand to pay for its operating expenses.
5. Net Profit Margin
Of every dollar your company earns, how much is translated directly into profit? Determining your net margin can answer that, giving you an idea of how profitable your company is. The higher the ratio, the higher your profit margin.
6. Return On Equity
Shareholders have questions of their own, like ‘Is my investment being turned into profit?’ Your company’s ROE can tell you how profitable your shareholders’ investments are by measuring net profits for the fiscal year against the equity invested. A strong ROE is a clear sign that your company is effectively managing shareholder’s equity.
Determining your company’s debt-to-equity ratio can be a good barometer of its financial leverage. Debt-to-equity measures your company’s total liabilities against shareholders’ investments. Aggressive leveraging, for example, will produce a high debt-to-equity ratio. In order to operate, some industries need more capital on hand than others, so healthy debt-to-equity ratios vary from one industry to the next. If your company’s debt-to-equity is much higher than the industry average, potential investors may view your company as a high risk choice…
A second leverage ratio measures debt against assets. Like debt-to-equity, the higher your debt-to-asset ratio, the greater your company’s leverage. And, once again, if the ratio is significantly higher than the average debt-to-asset ratio in your industry, your company may be viewed as a risky investment.
Is your company healthy? It’s not an easy question to answer, but our favorite eight financial ratios should provide some insight into the relative health of your company.
Want more insight into the relative health of your company? Reach out to one of our pros at Delap to learn more.
Delap LLP is one of Portland’s largest local tax, audit, and consulting accounting firms, located in Lake Oswego, Oregon.