LUTZ BUSINESS INSIGHTS
How to Interpret Financial Ratios
CLARKE BELLER, audit director
Financial ratios are some of the core tools that companies can use to determine their overall financial health. While financial ratios can uncover positive aspects of a business, they can also uncover red flags, essentially offering a marker for those areas where more in-depth analysis is necessary. Key decision-makers in every company should have a basic understanding of the most common types of financial ratios, how and when to use them, and how to spot troubling data/trends.
Four Common Ratios
1. Liquidity Ratios
It’s important for companies to have enough assets and cash flow to cover their financial obligations. Two ratios that can give decision-makers insight into this are the current ratio and the quick ratio. The ratios are calculated as follows:
- Current ratio = current assets / current liabilities.
- Quick ratio = (cash + marketable securities + net accounts receivable) / current liabilities.
Ideally, the current ratio will be greater than 1:1, meaning an organization has the ability to meet liabilities as they come due. The quick ratio provides a clearer picture of how much liquidity (cash, etc.) a company has, which is helpful in the event it must pay debt within a short period of time.
2. Profitability Ratios
Three basic profitability ratios provide insight into how easily a company can generate earnings compared to its expenses. Each is calculated as follows:
- Gross profit % = gross profits / sales.
- Operating Expenses % = operating expenses / sales.
- Net profit % = net earnings / sales.
The gross profit %, or gross margin, indicates how much excess profit is available to pay its operating expense. The operating expenses % is a measure of management efficiency. The more efficient management controls operating expenses, the more cash a company will have to save or invest. Lastly, the net profit % is a measure of how much each sale results in net income.
3. Leverage Ratios
Leverage ratios help a business evaluate its level of debt vs. its capital structure. These ratios include the total debt to equity ratio and the DSCR (debt service coverage ratio), which can be calculated using two different formulas.
- Total debt to equity = total liabilities / total equity.
- DSCR = (earnings before interest, taxes, depreciation, and amortization (EBITDA)) / annual debt service.
- DSCR = EBITDA / (principal + interest payments).
The total debt to equity ratio indicates the proportion of debt and equity a company uses to finance its assets. For the first DSCR formula, the annual debt service consists of the current long-term debt plus interest. Both DSCR formulas measure the amount of cash flow available to meet a company’s annual debt service requirements.
4. Efficiency Ratios
Efficiency ratios offer a snapshot of how well a company is utilizing its assets and meeting its liabilities.
Accounts Receivable Turnover Ratio
This ratio is calculated as sales / average accounts receivable. The accounts receivable turnover ratio indicates the efficiency rate in which a firm manages the credit issued to their customers and how well they collect on the credit. The higher the ratio indicates a more positive outlook for a company’s quick cash conversion cycle.
Days in Accounts Receivable Ratio
This ratio is calculated as 365 / account receivable turnover (if calculated on an annual basis). This ratio indicates the general number of days a sale sits in accounts receivable. If a company collects its receivables within 30 days, its accounts receivable turnover = 12.
Accounts Payable Turnover Ratio
This ratio quantifies the rate at which a firm pays its average payable amount. The ratio is determined as follows: cost of sales / average accounts payable. A higher turnover rate indicates a strong ability for a company to pay its vendors.
Days in Accounts Payable Ratio
This ratio is calculated as 365 / accounts payable turnover into 365 (if calculated on an annual basis). This figure gives a general indication of the number of days a purchase sits in accounts payable. If a company remits its payables within 30 days, its accounts payable turnover = 12.
Inventory Turnover Ratio
The calculation for this ratio is cost of sales / average inventory. The ratio provides insight into how many times inventory is sold and replaced over a given time period. A low turnover ratio is typically interpreted as a reflection of excess inventory, poor sales, or both. A high turnover ratio can indicate strong sales, ineffective buying on the part of the company, or possibly both.
Days in Inventory Ratio
This ratio is calculated as 365 / inventory turnover (if calculating on an annual basis). This ratio is an indication of how many days it takes to sell current inventory on hand. If the turnover ratio is 9, then it takes a company 40 days to sell its inventory. If they have a turnover ratio of 30, then it takes only 12 days to sell all its inventory.
When to Review Ratios
Now that decision-makers have an idea of all the valuable insight that ratios offer, it’s important to know how often they should be reviewing these figures. As with most budgets and other financial information, these ratios should be reviewed monthly. Decision-makers should plan to study these ratios alongside their firm’s other documents such as:
- Their comparative balance sheet.
- Income statement (comparative and YTD).
- Reconciliation statements supporting the balance sheet.
- Reconciliations for the income statement such as sales, division reports, etc.
One of the main purposes of evaluating financial statement ratios is to determine whether there are any weaknesses that require a more in-depth look. Some red flags that would encourage further analysis include:
- Rising debt to equity ratio.
- Notable other income/expenses.
- Declining gross margin.
- Unstable cash flow or operating cash flow </= net income.
- Rising AR or inventory in relation to sales.
- Current ratio less than 1:1.
- Significant related party transactions.
Reviewing your financial statements and ratios together provides a greater understanding of which aspects of a company are performing well and which areas need improvement. The next step is to dig deeper and ask why some parts of a company are functioning well, whereas other areas may need improvement. The components that make up the various ratios are the starting point of analysis to find answers. If you’d like more information about interpreting ratios, please contact us. You can also find related blogs here.
ABOUT THE AUTHOR
CLARKE BELLER + AUDIT DIRECTOR
Clarke Beller is an Audit Director at Lutz with over 11 years of experience. He specializes in providing auditing and consulting services to privately held companies and employee benefit plans with a focus on the construction industry.
AFFILIATIONS AND CREDENTIALS
- Nebraska Society of Certified Public Accountants, Member
- American Institute of Certified Public Accountants, Member
- Certified Public Accountant
- BSBA in Accounting, University of Nebraska, Lincoln, NE
- MBA, University of Nebraska, Omaha, NE
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