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The health of any company depends on several factors. However, a single glance at earnings figures or expenses does not provide enough information to make a firm determination about that company’s viability. For example, Company A shows $1 million in sales of computers during Year 1 of operation. In Year 2, this increases to $2 million, twice that of Year 1. So, an increase in sales is always good, right? Not necessarily. In the case of Company A, the business sold fewer units overall, incurred greater expenses, and therefore had overall lower profitability.
A better barometer to gauge the health of any business is the assessment of certain key financial ratios that check various aspects of a company’s financial performance.
Dividing a company’s total liabilities or debt by the amount of shareholders’ equity generates the Debt/Equity ratio of a company. This measures the amount of equity and debt incurred by a company to finance its assets.
A high debt/equity ratio could mean that the company uses a higher percentage of debt to fund operations, as opposed to funding operations through equity. Conversely, if the debt used to fund operations is less than the earnings generated by using it, then it is beneficial to the shareholders.
In addition, if debt financing costs prove to be higher than the cumulative returns, it can lead to an unstable situation for the company and affect future prospects.
This is also called the Assets/Debt ratio. The assets/liabilities ratio measures the percentage of assets financed through debt. It is calculated by dividing the total debt or liabilities of a company by its total assets. It is different from the Debt/Equity ratio where debt is divided by the amount of shareholders’ equity.
This ratio provides a measure of the company’s short-term liquidity. A healthy asset to liability ratio is one where there are twice as many assets as liabilities. A higher proportion of debt indicates poor financial health.
Profit margin (Net Income/Sales):
The profit margin ratio reveals the profitability of a business or the amount of profit earned per dollar of sale. It is calculated by dividing net income by the total revenue, resulting in a percentage. Thus, a profit margin of 16% means that the company made a profit of $0.16 per dollar. In this ratio, net income is defined as the difference between revenue and cost.
This ratio is valuable when conducting comparisons of similar companies. Profit margin shows whether the company’s pricing strategy is viable or not. Higher margins indicate better control over pricing. Also, profit margins are a better comparison metric than total earnings, as profit margins take into consideration operating costs and inventory expenses.
The inventory turnover ratio reveals the speed at which a company moves its inventory. To calculate inventory turnover ratio, divide total sales by figures of average inventory for the period you are evaluating.
A high turnover ratio indicates that the company is moving inventory at a rapid pace, or managing good sales, whereas as a lower ratio could point to inventory not converted to sales, or a poor return on investment. Inventory movement can also be dependent on particular seasons. Hence, average figures are considered when comparing financial health of different companies.
Return on Assets:
The return on assets ratio reveals the profitability of a company’s total assets. The ratio proves useful when assessing the viability of using the company’s assets in generating revenue. The return on assets is calculated by dividing net income, or revenue earned, by the total amount of assets owned. When evaluating this ratio, it is important to remember that it is dependent upon the industry in which the company operates. Also, if a company incurred a heavy initial investment, it will have a lower return on its assets.
Consistent monitoring of these key ratios should provide you with adequate information to assess whether or not your business is on the right track, financially.
Satish Patel, CPA
President, Analytix Solutions
Satish Patel, Founder-CEO of Analytix Solutions, has more than two decades of experience as a CPA. He has also advised small and mid-sized businesses on diverse matters such as valuation, accounting, and finance. His experience extends to raising capital and arranging for finance from angel investors.
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