CEOS SHOULD NOT MISS : 12 VITAL FINANCIAL RATIOS

Financial Ratios

A CEO (by whatever name called), being the leader of an organisation has an ultimate responsibility of running the entire organisation. Good CEOs should not miss some of the financial ratios and always ensure (either themselves, or with expert assistance) that finance, the foundation on which a business runs, is well managed and stable.

By looking at few important financial ratios, he can largely judge the overall efficiency of the business, locate weakness, take sound decisions and hence, ensure financial well being of organisation.

I have compiled some of the important financial ratios that will give you a major idea about the company’s financials. If you are short of time, just read summary. Let’s find out what these ratios communicate:

Hello cash flows, how are you doing? Check liquidity ratios to find out.

I. Liquidity Ratios: They tell you about cash flow position of business. Higher they are (upto certain level), better it is! These are:

  1. Current Ratio: Current Assets/ Current Liabilities
    Summary: Current ratio reflects ability of business to meet its short term obligations. Current Ratio less than 1 indicates that company’s short term liabilities are higher than its current assets, which is not a good indication of financial health. However, too high Current Ratio (more than 3) is neither a good sign

    Detailed:
    Current ratio reflects ability of business to meet its short term obligations. Do you want to ensure good cash flows? If yes, then aim for moderately high current ratio. ‘Moderately’ high, please note.
    Higher current ratio indicates higher ability of business to pay its short term debts, yes, it’s a positive indication. Current Ratio less than 1 indicates that company’s short term liabilities are higher than its current assets, which is not a good indication of financial health.
    However, too high Current Ratio (more than 3) is neither a good sign as it indicates company is not using its funds efficiently. You can make better use of resources in this case, maybe!
  2. Quick Ratio/Acid Test Ratio: (Current Assets-Inventories)/ Current LiabilitiesSummary: It judges company’s ability to pay its short term liabilities with most liquid assets (cash and cash equivalents, marketable securities and accounts receivable). As evident, it excludes inventory. Higher the quick ratio, better is company’s health.

II. Profitability Ratios: Monitor your profit margins. Higher they are are, better it is!

  1. Gross Profit Margin: (Revenue-Cost of Goods Sold)/Net Revenue
    Summary: Cost of Goods Sold= Opening Stock+ Purchases+ Direct Expenses- Closing Stock
    Is product/service price ideal? This ratio can help! Gives you margins earned in goods produced/service provided.

    Detailed: Gross Profit Margin reflects product cost and pricing decision of the company. If your gross profit margin is 30%, it indicates you spend 70% to produce the product/ provide service. Higher gross profit margin than industry indicates higher competitive edge of the company. When your margins are pretty high, you have room to reduce price and gain market share.

  2. Operating Profit Margin: Earnings Before Interest and Taxes (EBIT)/Net RevenueSummary: EBIT= Gross Profit- Operating expenses, excluding interest charges
    Operating margin indicates company’s profitability from its operations. It is also an indicator of company’s ability to pay interest on debt keeping in mind the leftovers.

    Detailed: Gross Profit margin was good, but you have many other expenses. Salaries, administrative, marketing and many more. Did we include them in Gross profit margin? No. We include them here in operating profit margin, as they are part of operations.
    Operating margin indicates company’s profitability from its operations. It is also an indicator of company’s ability to pay interest on debt keeping in mind the leftovers.
    Example: 20% Operating Profit would mean that company earns 20% profit from its operations excluding interests and taxes. So, higher, the better!

  3. Net Profit Margin: Profit After Tax (PAT)/Net Revenue
    Summary: It measures the net profit earned by the company on the sales made after paying all the expenses and taxes.

    Detailed: This is the ultimate profit margin you were waiting for!
    This ratio measures the net profit earned by the company on the sales made after paying all the expenses and taxes. It indicates how much value has the company made for its shareholders. Higher the net profit margin, better is the company. And, happier you are. 😉

  4. ROE (Return on Equity): Profit After Tax (PAT)/ Net Worth
    Summary: It measures profit attributed to shareholders in return for investment put in.

    Detailed: You invested your money. You want return. How much return you earned on money invested? Ask this ratio.
    Return on Equity measures profit attributed to shareholders in return of investment put in by them on the company. Higher ROE gives assurance to equity investors that their funds are utilized in right direction and are giving them good returns. Needless to say, higher the better!

  5. ROA (Return on Assets): Profit After Tax (PAT)/ Total Assets, excluding fictitious assetsSummary: It reflects efficiency of the business in utilizing its assets.

    Detailed: Quite similar to Return on Equity, ROA reflects efficiency of the business in utilizing its assets. How much profits have been generated by the company by employing assets. Just like ROE, higher ROA also indicates better financial health of the company.
    If difference between ROA and ROE is large, it means company has employed lot of debt. In that case, it is advisable to have a glance at solvency and liquidity ratios.

III. Activity Ratios: Test management’s performance using these ratios.

  1. Debtors Turnover Ratio: Net Credit Sales/ Average Debtors
    Summary: It indicates company’s efficiency in collecting its dues from debtors.Detailed: How soon are you recovering from your debtors? This ratio indicates company’s efficiency in collecting its dues from debtors, conversion rate of debtors into cash in order to maintain cash flows and avoid bad debts.
    High debtors turnover indicates company is efficient in collecting cash from debtors but if it is too high, it may also reflect strict credit policy which can make company lose its customers to peers.
  2. Creditors Turnover Ratio: Credit Purchases/ Average CreditorsSummary: reflects how swiftly a company pays off its creditors.

    Detailed: Ok, now how soon are you paying your creditors? Creditors’ turnover ratio can tell. It reflects how swiftly a company pays off its creditors. Since, payments to creditors mean reduction in cash, it should have a good balance between cash flows and utilization of credit period as well as discounts availed on early payments.
    High ratio means company is paying off creditors quickly, thereby reducing cash balance. However, company might also be availing early payment discount and vice-versa.

  3. Inventory Turnover Ratio: Cost of Goods Sold/ Average Inventory

    Summary:
     It indicates movement of inventory from the company. High inventory turnover means company is selling at a faster rate.Detailed: Are you selling your goods slow, fast or too fast? This ratio indicates movement of inventory from the company. High inventory turnover means company is selling at a faster rate, which is a good indication. Lower inventory turnover indicates that lots of resources are tied up in inventory and selling is slow. Again, coming to second side of story, too high inventory turnover could mean that company could get stock out in case demand is very high. Be wary of that.

IV. Solvency Ratios: You don’t wish to get bankrupt! Then, pay attention to these

  1. Debt-Equity Ratio: Total Debt/ Shareholder Funds Summary: It indicates debt that company has raised to finance its total assets as against the equity.Detailed: Ratio of 1:1 indicates that debt raised is equal to amount belonging to shareholders, and in case of theoretical winding up, creditors/lenders will have all the claim over company’s assets leaving no claim for shareholders. D/E ratio of 2:1 or 3:1 is ideal depending on the industry.Presence of leverage boosts up the Earning Per Share. Hence, suitable balance should be maintained between solvency risk and EPS.
  2. Interest Coverage Ratio: Earnings before Interest and Taxes (EBIT)/ InterestSummary: indicates ability of a company to meet its interest obligation from earnings generated.

    Detailed: Are you able to earn enough to pay interest on your debts? This ratio indicates ability of a company to meet its interest obligation from earnings generated. Higher the ratio better is the company’s ability to meet its interest obligation. Interest coverage ratio of 3 times indicates that earnings are 3 times the interest amount and hence, is perceived positively from both company and the lenders

Oh, and keep in mind, that ratios will vary from industry to industry and over time. Every ratio tells two stories. Interpreting them requires knowledge of your business, your industry and the reasons for fluctuations. If any assistance is needed, you can always ask Moneyम्जी. We can offer sound advice, which can help you interpret and improve your financial performance. It’s important to keep in mind that ratios are only one way to determine your financial performance. Beyond what industry a company is in, location can also be important

When you take care of above points, ratios give you great insight about financial health of your business.

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