Many times, I meet entrepreneurs and small business owners who enthusiastically tell me that they successfully created a set of financial statements by themselves. Their eyes will often tell you their story. Those of a parent boasting with pride and seeking external validation for their child. Of course, I agree being able to create a proper set of financial statements is essential for any business owner. But what is even more important is understanding it. What really is your balance sheet, income statement, and statement of cash flows telling you? Are you only able to decipher that you have positive income or that you’re not cash flow negative? If that’s all you can tell, then you’re probably not able to gauge the financial health of your business. Do you know how liquid your company is? Can you cover all your short-term liabilities? What is your profit margin? All this can be obtained by understanding and analyzing the data presented in your financial statements.
Have no fear, financial ratios are really not that complicated. In its simplest explanation it’s a ratio (a numerator over a denominator) that paints a quick picture of how your company is doing. Now, there are a plethora of ratios that you can use, but for the purposes of not making this article into a semester long text book, I will only concentrate on the 4 most common ones.
- Current Ratio – measures your business’s ability to pay back its short-term obligations. In short, it’s a measure of liquidity. Typically, current means a time frame of 1 year. Although, accounts receivable and accounts payable may have a shorter time frame as anything over 90 days may be considered “aged”.
Current Ratio = Current Assets / Current Liabilities
Current assets consists of cash, liquid investments, accounts receivable, and inventory. Anything that can not easily be converted into cash is not considered current. Buildings, office furniture, equipment, and raw materials used for manufacturing are good examples of what would not be included. Current liabilities are debts or obligations that must be paid in current year or cycle. Typically, this would include accounts payable, rent, utilities, and the current portion of a mortgage. Debt that falls into longer time frames, such as years 2-30 of a 30 year mortgage, would not be included.
For example, if a company has $200,000 of current assets and $100,000 of current liabilities, then the current ratio would be 2 ($200,000 / $100,000). A ratio of 2 represents that the company is in a good position to meet immediate liquidity and creditor demands. If the reverse were true, in which the company had $100,000 of current assets and $200,000 of current liabilities producing a ratio of .5 ($100,000 / $200,000), then what is that telling you? That the company is not very liquid. In the event that all obligations come due at the same time, and the company was not able to obtain additional financing, then there’s a high probability the company may become insolvent. But don’t assume the higher the current ratio the better the company is. If the ratio is too high, it could indicate that you’re not efficiently using your resources. It might indicate you have too much idle cash sitting in the bank and not deploying it into growing your company.
- Debt to Asset Ratio – measures how leveraged your company is. The equation indicates how your business assets are financed, either through equity or debt.
Debt to Asset Ratio = Total Liabilities / Total Assets
Total assets and total liabilities include the current and long-term portions noted on your balance sheet.
For example, if a company has $400,000 of total assets and $200,000 of total debt, then the debt to asset ratio would be .50 ($200,000 / $400,000). That means about half of your assets are financed through debt and the other half through equity. So how does this really affect you? If a company has a high debt ratio but needs additional funding from a bank or investor, they might see you as risky because a large portion of the company’s cash flows are used to pay principal and interest. Thus, they may decline to offer you funding. In the same sense, a low debt ratio may be viewed as inefficient usage of leverage opportunities to grow the business.
Alternatively, you can examine leverage through the Debt to Equity Ratio (Total Liabilities / Total Equity). Basically, this is flip side of the same coin. It also measures how much your company is financed by debt versus equity. So let’s expand on our equation above a little bit. If we used our good old accounting equation of Assets = Liabilities + Equity, then we see from the above data that we have $400,000 of assets derived from $200,000 of debt + $200,000 of equity. So our Debt to Equity ratio is 1 ($200,000 / $200,000). A ratio of 1 shows that your company’s debt and equity are equal to each other. The higher your debt to equity ratio is, the more you are financing your company’s growth through debt, which increases your risk for solvency.
So what make a good debt ratio? This all depends on what your industry average is. Or if you want to benchmark yourself against a similar public company, you can review their financial statements in their 10k filings. For example, if you are in the fast food business and you want to benchmark yourself against McDonald’s. You can do a quick online search and see that for 2011, the company had a debt to equity ratio of .87 compared to an industry average of about 3.5. This means that McDonald’s is relatively less risky and less leveraged than its competitors. You can strive to operate your company within the same range.
Net Profit Margin – measures how profitable a business is. It shows how efficiently your business converts sales dollars into profit after all the expenses are accounted for.
Net Profit Margin = Net Income / Total Revenues
Net income is essentially all your revenues less all your expenses, or really just your bottom line.
For example, if your company has $100,000 in sales and $25,000 in expenses, then your net profit margin is .75 or 75% (($100,000-$25,0000) / $100,000). That means for every dollar of sales you make 75cents of it is profit. Not too bad!
Why does it matter? Because if a company can’t convert enough sales dollars to profit, then eventually they may have to shut down. In addition, the net profit margin can be used to examine how your company is doing over time. If your margin is trending downwards, it may indicate that you need to either adjust your pricing strategy or your costs are increasing at a higher rate than your revenues.
Now, there are many more ratios that a business owner should understand. But reading this provides you with a good first step in gauging how your business is doing. You might have noticed that you can use these same ratios in analyzing whether to buy certain stocks. The concept is the same. It’s a measure of financial health.