It has happened to all of us. Driving down road, you hear a beep in the car and see a warning light on your dashboard, telling you something on your car needs attention. The light may look like an old-fashioned oil can, an engine, a tire with an exclamation point, or something else you have to look up in the owner’s manual. You know it’s a problem, and something must be done to make sure it doesn’t turn into a bigger problem.
Financial metrics can be that light on your business dashboard. They can tell you if things are going well or when things might need a little extra attention. However, financial metrics on their own provide very little value. The value is in the comparison of financial metrics over time. Identifying the trends in financial metrics should help you identify what is working and where there are opportunities for improvement.
It’s also helpful to add some context to financial metrics by comparing them to industry statistics. However, these benchmarks must match your company’s operations and should be based on similarly sized companies, or the industry comparison loses some value.
The four financial metrics listed below are the “warning lights” to consider adding to your business dashboard to help you identify where there might be some bumps in the road.
Liquidity Ratios
Liquidity ratios are used to measure the company’s available operating liquidity, which the company uses to fund its day-to-day operations, as well as to measure its ability to pay short-term obligations as they come due.
Examples of liquidity ratios include:
- Working Capital Ratio. This is calculated by dividing current assets by current liabilities.
- Quick Ratio. This is calculated as cash and cash equivalents, plus marketable securities, plus accounts receivable over current liabilities.
Generally, the higher these ratios, the larger the company’s margin of safety to pay its current obligations. However, be aware of having too much of a good thing. A company with very high liquidity ratios may be missing out on opportunities to invest in the business or otherwise generate a higher return on its assets.
Leverage/Coverage Ratios
Leverage/coverage ratios are used to measure a company’s ability to repay its long-term debt, interest, and other long-term obligations as they come due, and have a longer-term focus than liquidity ratios. These ratios are often used by lenders when evaluating the credit worthiness of a borrower.
Examples of leverage/coverage ratios include:
- Debt to Equity Ratio. This is a measure of financial health which focuses on the company’s ability to fund its debt in event of a business downturn. It is calculated by taking total debt outstanding over total equity and can be used to assess how a company finances its operations.
- Debt Service Coverage Ratio. This is a measure of financial health which focuses on the company’s ability to generate enough income to cover its annual debt service. It is calculated by taking net operating income, or earnings before interest and taxes (EBIT), over aggregate annual principal and interest payments on all debt outstanding. A debt service coverage ratio of one illustrates that the company is generating just enough net income to cover annual principal and interest payments, so a ratio above two is generally considered to be good.
Profitability Ratios
Profitability ratios are used to measure how well the company generates profits from its operations. While profitability ratios can be performed on the company as a whole, more granularities will likely yield a better analysis. Profitability by service line, by product, or by customer is likely to yield more useful information than looking at the company as a whole.
The most common profitability margin is gross margin. Measuring gross margin (gross profit divided by sales) by product line and/or customers is a good way to identify situations in which margins may be lagging other product lines. This measurement can help management focus on those areas that are most profitable and maybe even discontinue those that are lagging.
Other common profitability ratios include:
- Return on Assets. This is a measure of the income generated by the company’s assets. It is calculated by dividing net income for the period by average assets for the period. Return on assets will vary greatly depending on whether the company is an asset intensive business (such as a manufacturer), or not an asset intensive business (such as a professional services company).
- Return on Equity. This a measure of the income compared to the company’s capital. It is calculated by dividing net income for the period by average equity for the period, and the higher the ratio, the better.
Return on equity does not consider the company’s debt, so if one company has a return on equity of 28 percent and another has a return on equity of 14 percent, it is important to consider how much debt (or leverage) each of the companies has before concluding that the company with a return on equity of 28 percent is performing better than the one with a return on equity of 14 percent.
Efficiency Ratios
Efficiency ratios are ratios used to measure how well a company uses its assets. Efficiency ratios are important because improving them often results in improved cash flow.
Efficiency ratios to consider monitoring include:
- Days Sales Outstanding (DSO). DSO is a measure of the number of days it takes a company to convert its accounts receivable into cash. It is calculated by multiplying the quotient of average accounts receivable over sales for the period by the number of days in the period.
It is important to note that DSO excludes cash sales. A DSO of around 45 is generally considered to be good, but this is certainly not a hard and fast rule. It depends on payment terms that are common in the company’s business and the type of customer. For example, a retail store may have a DSO of six to seven, while a defense contractor may have a DSO of 80. - Days Sales in Inventory (DSI). DSI is a measure of the average time it takes a company to convert its inventory into sales. It is calculated by multiplying the quotient of average inventory over cost of goods sold for the period by the number of days in the period. DSI metrics also vary significantly by industry. For example, a produce retailer would have a much lower DSI than auto dealer.
DSO and DSI provide the most value when tracked over time. If these metrics are trending upward, they can serve as an early warning indicator of potential issues, including customer creditworthiness, a breakdown in the collection process, accumulation of inventory, or other potential pitfalls.
Including these financial metrics in your reporting package and monitoring the changes over time will help you evaluate the health of your business. These financial metrics, like the lights on your car’s dashboard, serve as an early warning, allowing you to identify the cause of the issue and correct it before it becomes a bigger problem.
If you have any questions or would like to discuss how your company can effectively monitor important financial metrics, please contact us.