Comparing a business’s key financial ratios with industry standards and with its own past results can highlight trends and identify strengths and weaknesses in the business.
Financial statement information is most useful if owners and managers can use it to improve their company’s profitability, cash flow, and value. Getting the most mileage from financial statement data requires some analysis.
Ratio analysis looks at the relationships between key numbers on a company’s financial statements. After the ratios are calculated, they can be compared to industry standards — and the company’s past results, projections, and goals — to highlight trends and identify strengths and weaknesses.
The hypothetical situations that follow illustrate how ratio analysis can give company decision-makers valuable feedback.
Rising Sales, Rising Profits?
The recent increases in Company A’s sales figures have been impressive. But the owners aren’t certain that the additional revenues are being translated into profits. Net profit margin measures the proportion of each sales dollar that represents a profit after taking into account all expenses. If Company A’s margins aren’t holding up during growth periods, a hard look at overhead expenses may be in order.
Company B extends credit to the majority of its customers. The firm keeps a close watch on outstanding accounts so that slow payers can be contacted. From a broader perspective, knowing the company’s average collection period would be useful. In general, the faster Company B can collect money from its customers, the better its cash flow will be. But Company B’s management should also be aware that if credit and collection policies are too restrictive, potential customers may decide to take their business elsewhere.
Company C has several product lines. Inventory turnover measures the speed at which inventories are sold. A slow turnover ratio relative to industry standards may indicate that stock levels are excessive. The excess money tied up in inventories could be used for other purposes. Or it could be that inventories simply aren’t moving, and that could lead to cash problems. In contrast, a high turnover ratio is usually a good sign — unless quantities aren’t sufficient to fulfill customer orders in a timely way.
These are just examples of ratios that may be meaningful. Once key ratios are identified, they can be tracked on a regular basis.