A financial ratio has no single correct value. It depends on one’s perspective and the competitive strategy employed. Lenders like a high Current Ratio that suggests strong liquidity and high likelihood of repayment. From an operating viewpoint, the important question is not whether the current ratio is too high, but whether the chosen strategy is best for the company.
How do you interpret ratios and other key financial indicators? How do you decide whether a company is healthy or sick? One way is to compare a company’s ratios to industry ratios (you can look up this information in RMA studies at your local library) to see how a company measures up to its peers. Keep in mind, though, that company-specific differences can result in entirely justifiable deviations from industry norms.
The most useful way to evaluate ratios and indicators involves trend analysis (monthly), noting how the ratios change over time. Ratios that show a negative trend mean that less cash is coming in. Here are my most used and recommended ratios:
|Gross Profit Margin %||Gross Profit / Sales• This is your most crucial ratio as it measures the % of each sales dollar available for covering overhead and producing bottom-line profits|
|Monthly Overhead $||Expected Monthly Overhead Average for Current Year• This number (accumulated on your monthly P&L) will highlight any “creep” or outright jump; allowing you find the cause and take timely action|
|Interest Coverage Ratio||EBITDA (earnings before interest, taxes, depreciation & amortization) / Interest Expense• This measures how easily you can repay your borrowings. In good times this ratio should be at least 1.25; in bad times, only the banker knows|
|Current Ratio||Total Current Assets / Total Current Liabilities• This measures the ease with which you can pay bills as they come due. Ratios greater than 1 : 1 are easier to manage than 1 : 1 or less (e.g., .75 : 1)|
|Quick Ratio||(Cash & Accounts Receivable) / Total Current LiabilitiesThis ratio is a good measure of a company’s short-term cash position. A ratio of less than 1:1 means you’ll have to decide who gets paid when the next dollar comes in. A worsening condition (i.e., a number lower than 1 in the first postion) means your sales aren’t keeping up with your bills|
|Days’ Sales in AR||(Accounts Receivable / Sales) x 365• This number indicates the days, on average, your customers take to pay you. 45 and under is good; 60 and above is bad. If this number rises it means you have less cash coming in and may have to borrow money to pay bills|
|Days’ Sales in AP||(Accounts Payable / Sales) x 365• This is the number of days, on average, you take to pay your suppliers. The closer this number is to the AR number, the easier it will be on cash flow. Generally, you should pay your suppliers as close to “terms” as possible to maintain good relationships, and focus on tightening your AR collections times|
|Days’ Sales in Inventory||(Inventory / Sales) x 365• This indicator measures the amount of time to convert inventory into sales. This is another crucial number because you have to create a sale—and then collect that sale. Bottom line: if this number is higher than the industry median, be sure there’s a valid reason|
|Debt to Equity Ratio||Total Liabilities / Total Equity• You should pay close attention to this ratio. In tough credit markets you want bankers to see you as a good candidate so manage this ratio by putting more equity into the business or by converting your loans to equity. A higher ratio will force you to focus intently on cash flow and paying down debt—to the exclusion of business-building activities. What is a good ratio? Only the banker knows|