While retail math is useful for merchandise companies, financial ratios are used for all types of corporations. These metrics are useful to further analyze retail businesses, as well as assess all companies’ health and determine where their strengths and weaknesses lie. This chapter examines metrics that assist in inspecting whether the example company has enough cash to cover its expenses in the short term, whether the debt and obligations are too large to cover the expenses, whether the company is turning a profit, and whether the company is efficient in using its resources. The ratios explained in this chapter are illustrated with the financials used for the previous chapter’s fictional company on the Cash Flow and Financial Ratios tabs of Appendix A, which has already been downloaded.
Financial Ratios at a Glance
Financial ratios, like retail math metrics, enable a company to further determine its financial health. Financial ratios measure how much liquidity, debt or leverage, profitability, and efficiency a company has. These ratios are important because they help a company assess the cash it has to spend, how quickly it’s spending on lines of credit or cash reserves, and whether it has enough cash to cover regular obligations such as rent, debt service, and operations expenses.
The liquidity is the current or short-term assets of some form over current liabilities of some form. Current means a time period of a year that is considered a short period of time. It specifies whether a company has the money to pay off its current debt and more.
The debt, sometimes referred to as the leverage ratio, indicates the risk that a company is carrying. The liabilities vehicle of a company may be debt, loans, interest rate, or taxes. Without a company having enough liquidity to cover the debt and more, they will be in a financial situation where they cannot pay back the credit they may owe.
The profitability ratio shows how much profit the company is able to keep from the amount of income earned. This ratio will help a company know how it grew and how it can plan for the future.
The efficiency ratios are sometimes referred to as activity ratios, and they give insight into how well the company manages its operations and sales activities. The goal of this metric is to show how the company produces income through the effective use of the company resources.
For these ratios, it is essential to know when the numerator (the number on top) and the denominator (the number on the bottom of a fraction) are the same and the result is 1. When the numerator is greater than the denominator, the result will be greater than 1, and when the numerator is less than the denominator, the result will be less than 1. For instance, when you look at the current ratio, to make sure the company is able to pay down its current liabilities, the result should be greater than 1. This will show that the assets are at least as large if not larger than the current liabilities.
Liquidity Ratios
Liquidity ratios measure how much time it will take a company to repay an obligation. It is the ability to meet the debt of the company as it is due. There are three main liquidity ratios: current ratio, quick ratio, and cash ratio.
Current ratio = (Current asset)/(Current liability)
This current ratio indicates how strong a company is and how well it is investing its capital. The current ratio is sometimes referred to as the working capital ratio, and it helps a company understand how it could cover its current liabilities within one year. Both current assets and current liabilities are on the balance sheet. Current assets include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than a year. The current ratio is a liquid asset or a vehicle to move around money quickly. It measures the ability of a company to pay off short-term liabilities quickly or those debts due within one year. The current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt.
A company with a current ratio less than 1 may not have the capital on hand to meet short-term obligations that are due. A company with a current ratio greater than 1.5 is, in general, doing well. This number may depend on what sector the company is operating under, how liquid the assets really are, how easily it may be to refinance its debt, and what the plans are to use excess assets. The current ratio, if less than 1, explains at a point in time that a company cannot pay its current debt; however, once those payments are received, it does not mean the company will not be able to pay the debt. Therefore, it may be difficult to compare different companies using only this metric because of what it measures.
The current ratio is increasing from 2xx0 (2.64) to 2xx1 (3.65). Both are good indicators. Both these KPIs for the company have current ratios greater than 1.5 and show that the company has enough short-term assets to cover the short-term debt.
The quick ratio has two formulas that both yield the same results.
Quick ratio = (Cash – Inventories – Prepaid (insurance or subscriptions))/(Current liabilities)
Quick ratio = (Cash + Cash equivalents + Accounts receivable + Market securities)/(Current liabilities)
This quick ratio, at times referred to as the acid-test ratio, measures a company’s ability to pay off short-term liabilities with assets on hand or current assets. A quick ratio of 0.95 means the quick assets are not enough to pay every dollar of current liabilities. A quick ratio of 1, however, indicates that a company’s quick assets are equal to its current assets. This conveys that a company can pay off its current debts without selling its long-term assets. When a quick ratio is greater than 1, it means that the company owns more quick assets than current liabilities, and that is a good indicator. As the quick ratio gets larger, so does the liquidity of the company; for the most part, this is a positive sign indicating that more assets can quickly be converted to cash. This can demonstrate that the quick cash is reinvested into productive use. However, it should be determined if the reinvestment is going into nonproductive use instead. Quick assets are the sum of the cash, cash equivalent (like money markets accounts, certificates of deposits, saving accounts, treasury bills that mature within 90 days), and receivables of a company. It does not include other current assets such as inventory and prepaids (such as prepaid insurance), which can quickly turn into cash.
The current liabilities are obligations that must be paid within a year. They include interest on long-term debt that is paid within the next year. These liabilities may include taxes, wages, insurance, and utilities.
The quick ratio is a financial indicator of the ability to raise cash to pay bills due in the next 90 days. Quick ratios vary from industry to industry and may be seasonable. During difficult economic times a company may want to increase their quick ratio to deal with unforeseen shocks or turbulent times in the market. If a company has difficulty collecting accounts receivable, it may be good to increase cash so that you have money to cover the balance. If a company is growing, they may have a higher quick ratio in order to pay for investments and newly created investments.
If the quick ratio is 2.0, it means the company is able to quickly access its assets because they are two times the value of its short-term liabilities. Therefore, the company is liquid. However, if the quick ratio is 0.5, the company’s quick ratio is half its short-term liabilities, and the company would not be able to cover its short-term liabilities. This ratio could be compared to other companies in the same sector to determine how it is doing.
The quick ratio is increasing, which also is a positive from 2xx0 (2.32) to 2xx1 (3.31). This quick ratio shows that the company is able to pay off its short-term liabilities quickly.
The cash ratio is a liquidity ratio that measures a company’s ability to pay off short-term liabilities with highly liquid assets.
The cash ratio is a more conservative measure of the liquidity of a company position than the current ratio. A cash ratio of at least 0.5 to 1 is usually preferred for retail companies. However, cash ratios may not provide a good overall analysis of a company because it may be unrealistic for a company to hold large amounts of cash, particularly for startup, and small and medium-sized companies.
Cash ratio = (Operating cash flow)/(Current liabilities)
The cash ratio or cash asset ratio is a more conservative ratio where only cash and cash equivalents—the most liquid assets—are included in the calculation. Cash, for example, is cash, checking account, and bank drafts. Cash equivalents are assets that can be converted very quickly into cash, such as saving accounts, T-bills, and money market vehicles. Again, short-term liabilities include short-term debt, accrued liabilities, and accounts payable.
A ratio of 1 means that a company will be able to pay off the current liabilities with cash and cash equivalents with some funds left over. When the ratio is high, it indicates that the company can pay off its debt. However, a ratio too high may mean that the company is not using its assets right and investing in the company instead of letting the funds sit around. A ratio of 0.5 to 1 is preferred.
The cash ratio is increasing from 2xx0 (0.65) to 2xx1 (1.65). Since the cash ratio is even higher than the suggested rate of 1, the company is doing well even with the most conversative ratio for liquidity. However, the company needs to investigate if it should invest rather than just hold onto the money.
For the dress company, all of the KPIs at this point tend to suggest that the company is able to pay and repay its current loans and obligations.
Debt or Leverage Ratios
Leverage ratios are used to measure the debt level and obligations a company has. There are three leverage ratios discussed here: the debt ratio, interest ratio coverage, and debt service coverage. The debt ratio determines how much debt there is compared to the assets the company has. The interest ratio coverage shows if a company is able to pay off the interest expense given the EBITDA. The debt coverage indicates how much debt can be paid off with the company’s operating income.
Debt ratio = (Total liabilities)/(Total assets)
This debt ratio is a company’s amount of assets carried from their debt. And, if the company does hold debt, how does its credit financing compare to its assets? A higher ratio shows a higher rate of debt financing.
Lower ratios show better creditworthiness and are preferred, but too little debt has its own risks. A ratio of 0.4 or lower is considered better since the interest on a debt must be paid regardless of business profitability. A debt has interest risk and is interest risk sensitive. The higher the interest rate, the harder it is to pay the debt back. A company may need to declare bankruptcy if it cannot service its own debt. Therefore, a ratio higher than 0.6 may have trouble borrowing money.
Larger companies have more leverage with their negotiating lenders and are able to carry more debt than startup and small and midsize companies.
The debt ratio is decreasing from 2xx0 (0.38) to 2xx1 (0.27). Both these ratios are lower than 0.6, so if the company had to borrow money, it probably could at a low rate.
Interest coverage ratio = (Earnings before interest taxes, depreciation and amortization (EBITDA))/(Interest expenses) during a given period.
The interest coverage ratio measure shows how much a company can pay interest on outstanding debt. Many creditors use this measure to assess the risk of lending capital to the company. A higher ratio is better, and each industry may have an ideal ratio. The lower the ratio, the higher a company is burdened by debt. A ratio of less than 1 means that the company is not meeting its debt obligations. A ratio between 1 and 1.5 or lower may indicate that the company cannot meet its interest expenses.
Interest coverage is looked at over time to see if it shows a pattern of worsening, improving, or remaining stable.
The interest coverage increased from 2xx0 (28) to 2xx1 (36), which indicates that the company is able to cover its interest payments without an issue.
Debt service coverage ratio = (Net operating income)/(Total debt service)
This measure shows how fast the company’s cash flow can pay off debt obligations. In other words, it indicates a company’s ability to pay back loans. A ratio of 1 or above is considered a positive sign that a company is able to repay its debt and interest payments. A ratio of 2 or higher shows that a company is able to not only pay off their loans but also carry another loan if need be.
The debt service coverage ratio is from 2xx0 (3.5) to 2xx1 (4.8). These ratios are above 2 and show that the company is clearly able to cover their loan and interest payments.
From the leverage ratio, the dress company displays an ability to cover all its debt obligations.
Profitability Ratios
Profitability is important for all companies, but this book focuses on startups and small to medium-sized companies. Profit is incurred when expenses are subtracted from the revenue. Without profit, the company will not be able to secure any additional loans, attract investors, or grow. There are many different types of revenue KPIs that companies use to evaluate their businesses. There are six forms of revenue-generating KPIs the book discusses: profit margin, gross profit margin, net profit margin, EBITDA, operating profit, and return on assets. Profit margin is the percent profit made from the revenue generated. Gross profit margin is the revenue less the cost of goods (COGS) and a way to evaluate pricing accuracy. Net profit margin, or simply net margin, is the net sales over the revenue generated. Although gross profit margin, net profit margin, and operating are types of profits the company can produce, these metrics were explained in Chapter 4 and will not be reviewed here; they overlap both sections. This chapter discusses profit margin, EBITDA, and return on assets.
EBITDA is the overall ability of a company to generate profit from sales when fixed obligations such as taxes, depreciation, and amortization are considered. This is in the income statement. Return on assets shows how well a company turns its assets into money generated. All the profit metrics help determine how much money the company makes and, therefore, how well the company is managing its resources and how much profit the company could expect in the future.
Profit margin percent = (Revenue – Total expenses with the cost of goods)/Revenue*100
The profit margin indicates how a company is handling its finances, and, more specifically, it compares the profit to sales. Profit margin tells the company how many cents per dollar the company generated for each dollar in sales. In general, a company with a profit margin percent over 20 percent is considered good and below 5 percent is not doing well, but this ratio can vary by industry and size of the company, as well as by other factors.
On the spreadsheet, the profit margin percent stayed stable from 2xx0 (70 percent) to 2xx1 (70 percent). The margin is remaining stable, and it shows that the company is making a marked profit. This profit margin percent is a bit high for a real company, but a more attainable profit margin percent is around 50 percent or more.
EBITDA = Net income – (Interest, depreciation, and amortization)
EBITDA means net income before interest, depreciation, or amortization.
EBITDA is a measure of a company’s profitability or overall performance and may give a clearer view of a company’s operations. EBITDA is used to measure a company’s ability to generate a profit from sales. It is used sometimes in lieu of net income, also called net profit, and it does not include items of capital and financial expenditures, such as property, plants, and equipment. This metric adds back interest and tax expenses but excludes debt.
EBITDA is a measure that can be compared to other similar companies because it combines the core elements of a company’s profit. A higher EBITDA is always better, and the number differs by sector, industry, and size of the company. Unfortunately, at times, companies use EBITDA to mask when the company has heavy debt and expensive assets.
The EBITDA increased from 2xx0 ($516,280) to 2xx1 ($625,036).
Return on assets = (Net income or profit)/(total assets)
Return on assets shows how well a company is relative to its assets. The net income comes from the income statement, and the total assets measure comes from the balance sheet. It gives the company owner a good idea of how well the assets generate earnings, in other words, how fast a product converts into cash and when the company can re-invest the cash. A return on asset over 5 percent is considered good.
The return on assets (ROA) increased from 2xx0 (47%) to 2xx1 (49%), and for both years these numbers are good.
Efficiency Ratios
Efficiency ratios are sometimes referred to as activity ratios. They give insight into how well the company manages its operations and sales activities. The goal of these activities is to produce income through the effective use of the company’s resources.
Inventory turnover ratio = (Quantity sold)/Average inventory on hand
Inventory turnover reports how a company is able to sell its merchandise. Inventory turnover is important because one of the company’s biggest expenses is inventory. Having too much inventory is costly because it takes up space and costs the company money to manufacture. The larger the inventory turnover ratio is, the faster a company needs to replenish its stock or else it will be at risk of running out of goods to sell.
Inventory turnover decreased from 2xx0 (2.63) to 2xx1 (2.3).
Inventory turnover demonstrates how many times a company has sold the merchandise and then replaced the inventory over a period of time. It is common to use sales or COGS, but sometimes it may be more useful to use units sold instead because it does not include markup costs or variable margins. Therefore, it may be a better predictor.
A high inventory turnover could indicate that the company has strong sales. However, it could also show that the company has insufficient inventory to cover all the sales. On the other hand, a low inventory turnover number could suggest that the company has excess inventory and weak sales. Therefore, this ratio will enable the company to decide on pricing, purchasing, and marketing of the product.
Average inventory = (Beginning inventory + Ending inventory)/2
The average inventory calculation for financial purposes is typically the inventory count at the beginning of the time frame and the end of the time frame, divided by 2. The average inventory for a time frame can also be the literal average of every inventory count available during the time frame, e.g., monthly, but sometimes these numbers can diverge.
The average inventory increases from 2xx0 (3,238 units) to 2xx1 (3,625 units), which implies a higher inventory liability for the time frame, and higher sales required to achieve strong turnover. Inventory liability is the risk of unsold merchandise via the cost of warehousing and marketing unsold merchandise until considered unsellable and disposed of, which also often involves a cost.
This fictitious company’s financial metrics show that this company has enough liquidity to pay down its short-term debt and interest and loans. The company is stable and conservatively leveraged. Many new to midsize companies find themselves over-leveraged, and they need to watch this carefully so that they do not take on too much debt to sink the company altogether. Profit, which is an important component of a company, is stable and thereby allows the company to get competitive rates if it needs a loan. The company’s inventory as well as the e-commerce department should be closely monitored to determine what the rate of each item turnover should be.
Summary
Analyzing financial ratios often is an essential part of any well-run and well-planned business practice. These metrics should be assessed frequently to ensure that the company can meet its short-term liquidity responsibilities to measure its accountability to pay off its debt and obligations owed. They are the most straightforward financial KPIs to demonstrate that a company is turning a profit and running an efficient business.