Ratio Review: Applying Financial Ratios for Meaningful Insight

Financial ratios provide a succinct set of data relationships that can be applied to for-profit and nonprofit organizations to reveal red flags, fraud signals, and financial statement incongruities. [Urbancic, The Power of Cash Flow Ratios] Comparing results across regional industry averages also offers a useful benchmark for managers and investors seeking to optimize returns or mission effectiveness, an exercise that can become a meaningful annual trend review. [Ibid]

At Navitance, we recently reviewed the performance of a client’s business line, added 3 years ago. Several key performance ratios for this new division varied significantly from the established lines of business (LOBs); in some cases performance lagged legacy LOBs, in others it exceeded. The insight gleaned from the ratio ranges not only pointed to inefficiencies, but also highlighted areas of competitive differentiation for the company to further leverage.

Different industries – and stakeholders – with disparate operational needs and return priorities will apply different ratio categories (as defined below). For example, manufacturers, distributors, and retailers rely on the fast conversion of inventory to cash to power operations. Through this lens, efficiency ratios are key to evaluating business health and identifying areas of dysfunction. Accounts receivable turnover ratios, part of the efficiency category, are also useful in evaluating the financial fitness of non-cash businesses, such as firms within the professional services sector. Liquidity and solvency ratios are useful to all companies, particularly those in a financial turnaround; with these ratios, company leaders and creditors will often look to evaluate short and long-term capacities to cover debt. For investors managing or evaluating an investment, profitability and financial leverage ratios offer critical insights into ROI and risk.

Common Classes of Financial Ratios
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  • Liquidity and Solvency Ratios evaluate a company’s cash in the context of its ability to pay off debt.

Liquidity Ratios refer to cash-on-hand and consider a company’s capacity to turn other assets – such as accounts receivable, trading securities, and inventory – into cash.

Common liquidity ratios include quick, acid test, current, working capital, and time interest earned ratios.

Solvency Ratios, similar to liquidity ratios, focus on debt payment but with a longer-term view of far-reaching obligations to creditors, bondholders, and banks. As a result, solvency ratios are more reflective of a company’s creditworthiness and fiscal soundness over time.

Common solvency ratios include debt to equity, equity, and debt ratios.

  • Efficiency Ratios (aka activity ratios) apply to the time it takes for a company to turn inventory and accounts receivable into cash. Management, investors, and creditors all monitor these ratios to determine a company’s operating profitability as well as areas for improvement.

Common efficiency ratios include accounts receivable turnover, working capital, asset turnover, inventory turnover, and days’ sales in inventory ratios.

  • Profitability Ratios reflect a company’s ability to achieve operational profit from its current assets. Similar to efficiency ratios, this measure helps outside capital providers, like investors and creditors, determine their return on investment vis-à-vis the company’s resources, assets, and efficiency.

Common profitability ratios include gross margin, profit margin, return on asset, return on capital employed, and return on equity ratios.

  • Financial Leverage Ratios measure the value of equity in a company via its overall debt picture. By comparing debt or equity to assets and shares outstanding, investors can determine the company’s level of leverage – more leveraged if creditors own the majority of assets, less if shareholders do – and assess the riskiness of its capital structure.

Common financial leverage ratios include debt, equity, and debt to equity ratios.

  • Coverage Ratios determine a company’s ability to pay its debt, but unlike liquidity and solvency ratios, coverage relates to obligations that aren’t typical liabilities, like regular dividend payments to stockholders and interest payments associated with debt service.

Common coverage leverage ratios include time interest earned, fixed charge coverage, and debt service coverage ratios.

To further explore how financial ratios can unlock insights into your business operations or inform your financial transition strategy, contact me at lglennon@navitance.com.