We live in an age of instant gratification so it does not surprise me that when I talk to business owners and executives about strategic planning, goal setting and metrics it is rare to find that they have a clear idea of the power of financial analysis and most do not even know where to start. They often ask me if financial analysis is essential to effectively guiding and leading their organization.
My answer is that [quotesright]simply knowing that you are making a “nice profit” and “are doing well” is not enough. [quotesright] If you want to operate and grow like Fortune 500 companies do year after year in this highly competitive environment, then you have to do the hard work they do and it all begins with a bottom-up financial analysis. I also point out that one of the Key Responsibility Areas (KRAs) for setting business and not-for-profit organization metrics is financial performance.
[quotes]It all begins with a solid income statement and balance sheet.[/quotes] It is hard to believe but far too often these financial instruments are in poor form and inaccurate. When that is the case the first step is to get these documents into shape.
Next, I recommend the following three steps to help gain an understanding of just how you are doing:
- Pull together a geocentric industry benchmark report. The idea is to get at least 100 companies in the same NAICS code as the business I am working with in as tight a geographic region as possible so the business owner(s) can get a good idea what the competition is doing.
- Create Financial Ratios. This is where the real hard work begins, creating the financial ratios, both general and industry specific.
- Perform a comparison to see how their business stacks up to the competition head to head.
You might be asking at this point, “Assuming I do all that, how do I make sense out it? How does this information help me run my business?” The following will help you begin to see the value and importance of this way of looking at your business’ performance.
The following briefly covers some of the basics of the four categories of ratios:
- Liquidity Ratios,
- Leverage Ratios,
- Profitability Ratios, and
- Activity Ratios.
1.Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet its short-term debt or in other words is there enough cash on hand to both cover your near-term needs and support growth initiatives.
I generally use the Quick Ratio (Cash + Accounts Receivable) / Total Current Liabilities. A general rule of thumb is a ratio of 2:1 to 2.5:1 represents a fairly strong cash position. [quotesright]Too low and the company operations can be bottlenecked and too high means that cash may be employed into the company to generate growth. [/quotesright]
Next, we look at the gross margin which is the gross profit percentage. Most businesses should maintain gross margins of 35 percent to 45 percent in order to be profitable in the long run.
Then we take a look at how your cost of goods sold match up to industry, paying close attention to direct labor hours, cost of materials and subcontractor costs.
Finally, we calculate your revenue and profit per Full Time Equivalent Employee (FTE) and compare to the industry average.
The calculations are Revenue / FTE and Gross Profit / FTE.
In certain industries it is important to perform variations of these calculations. As an example an extremely helpful calculation in a dentist office is revenue per chair and further breaking this down by specialty (e.g. hygienist, dentist, orthodontist, periodontist, etc.)
2.Leverage Ratios
Leverage Ratios measure the extent to which a company is financed by debt. The calculations are performed from data in the balance sheet hence the need for a balance sheet which many business owners either do not have or do not understand.
Common ratios that are used include the Debt to Assets ratio (Total Liabilities / Total Assets) and Debt to Equity ratio (Total Liabilities / Total Equity).
Comparing the amount of leverage a company is employing to the industry norms often [quotesright]reveals powerful go-forward strategies,[/quotesright] including reducing debt to increase company value or increasing debt to fund asset or initiative.
3.Profitability Ratios
Profitability ratios measure a firm’s ability to generate profits and, to a certain degree, management’s effectiveness. They are calculated from data in both the income statement and balance sheet.
Return on Assets also known as [quotesright]Return on Investment is one of the standard acid tests as it tells how much income is being generated by the assets employed. [/quotesright]
The calculation is Net Income / Total Assets.
Often, the Return on Sales calculation provides more strategic and tactical information as it shows how much profit is generated for each dollar in sales.
The calculation is Total Sales / Net Income.
[quotesright]Pricing strategies can be formed from this information. [/quotesright] Other standard profitability calculations include Return on Net Worth and Earnings Per Share.
4.Activity Ratios
Activity Ratios demonstrate how well a company is managing its resources. [quotes]The results of this type of financial analysis is often where the low hanging fruit lies[/quotes] in setting metrics and strategies to improve a company’s performance. Activity ratios are divided into two categories, Turnover Ratios and Cost Ratios. I will discuss a couple of ratios in each category.
a. Turnover Ratios
Inventory Turnover is a very important ratio for any retail-based firm as it defines does it have the correct amount of inventory on hand. [quotesright]Too high ratio means a company might be leaving sales on the table[/quotesright] and too low a number means that warehousing and other inventory associated costs are probably resulting in higher that desired overhead costs.
The calculation is Total Sales / Total Inventory.
Another important turnover ratio for most businesses is Average Collection Period. It answers the question of how long is it taking to collect on accounts receivable. This ratio varies significantly by industry from zero days for fast food restaurants to months for certain service industries.
The calculation is Total Accounts Receivable / Total Sales / 365 Days.
b.Cost Ratios
The most common cost ratio is the Cost of Goods Sold (COGS) ratio. The COGS ratio is the other side of the coin to the Gross Margin Ratio.
The calculation is Total COGS / Total Sales.
I highly recommend digging in much deeper when looking at COGS. Begin by taking a look at how your cost of goods sold match up to industry norms, paying close attention to direct labor hours, cost of materials, and subcontractor costs.
The other very common cost ratio is the Operating Cost Ratio. [quotesright]This ratio reveals how well the operations of the company are performing especially when compared to an industry average.[/quotesright]
The calculation is Selling, General and Administrative (SG&A) Costs / Total Sales.
Why is Financial Analysis is Essential
When a company commits to doing the hard work of performing financial analysis rigorously and reviewing results on regular intervals, management is assuring that not only is the company profitable but that they are targeting the right activities. [quotes]It will reveal if they are allocating too many or too few resources[/quotes] to sustain its position in the market and to be able to create tactics to grow its market share into the future.
I strongly recommend quarterly financial reviews as part of a larger company-level strategic performance review. The planned result is the updating of existing financial metrics and establishing other financial metrics based on the information.
Are you prepared to take your business to the next level?
If the answer is yes, then take a hard look into getting the professional business coaching support you need to do it right. Let’s talk, there is no obligation and we guarantee you’ll take away some valuable insights. Call: USA: 877.433.6225 or Email: feedback@focalpointcoaching.com
Below is a list of the most common financial ratios you can put to work right now to improve your business.
Formula Key – Financial Metrics
| Current Ratio | = | Total Current Assets / Total Current Liabilities |
| Quick Ratio | = | (Cash + Accounts Receivable) / Total Current Liabilities |
| Gross Profit Margin | = | Gross Profit / Sales |
| Net Profit Margin | = | Adjusted Net Profit before Taxes / Sales |
| Inventory Days | = | (Inventory / COGS) * 365 |
| Accounts Receivable Days | = | (Accounts Receivable / Sales) * 365 |
| Accounts Payable Days | = | (Accounts Payable / COGS) * 365 |
| Interest Coverage Ratio | = | EBITDA / Interest Expense |
| Debt-to-Equity Ratio | = | Total Liabilities / Total Equity |
| Return on Equity | = | Net Income / Total Equity |
| Return on Assets | = | Net Income / Total Assets |
| Fixed Asset Turnover | = | Sales / Gross Fixed Assets |
| Profit Growth | = | (Current Period Adjusted Net Profit before Taxes - Prior Period Adjusted Net Profit Before Taxes) / Prior Period Adjusted Net Profit before Taxes |
| Sales Growth | = | (Current Period Sales - Prior Period Sales) / Prior Period Sales |
| Sales per Employee | = | Sales / Total Employees (FTE) |
| Profit per Employee | = | Adjusted Net Profit before Taxes / Total Employees (FTE) |
- by Ben Pumphrey
Certified FocalPoint Business Coach & Trainer