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UsingFinancialRatios

September2009
By:ChristopherG.Gattis cgattis@BluePointStrategies.com www.BluePointStrategies.com

UsingFinancialRatios

September2009
By:ChristopherG.Gattis cgattis@BluePointStrategies.com Thefinancialstatements,profitandlossstatement,balancesheetandstatementofcashflows,offera glimpseintothefinancialhealthofacompany.Itisimportanttounderstandthattheseincome statementsareinmanyways,justanestimateoftheactualperformance.Forexample,werecord revenueatthemomentthesalesinvoiceisgenerated,oftenwithoutregardtowhethertheinvoicewill actuallybepaid.Manyotherbalancesheetitemsarealsoestimatesoftheactualperformanceofan individualassetorliability.Usually,theperformancedifferencebetweentheestimateandactualisso smallthathasrelativelylittlebearingonthebottomline.Sometimes,thedifferenceismaterial. Itisoftenchallengingtogetacompletepictureofacompanysfinancialhealthbyjustlookingatthe financials.Itsdifficulttocomparepastperformancetocurrentperformancebyjustlookingatthese statements.Financialratiosofferashortcuttounderstandingfinancialperformance.Ratiosare especiallygoodatcreatingtrendsofperformanceandcomparingonecompanytoanotherortoan industryaverage. Financialratiossimplyindicatetherelationshipofonenumbertoanother.Theyareeasilycalculatedby dividingonenumberbyanotherandexpressingtheresultasapercentageoranumberoftimes relationshiprepresentedbyadecimal.Thebeautyoffinancialratiosisthattheyprovidecomparisons thatrevealmoreaboutthefinancialhealthofthecompanythanjustthenumbersinthefinancial statementsalone. Withineachcategoryofratios,therearedozensofformalizedratiosusedbyoneoranothergroupor agency.Manyoftheseratiosarespecificallygearedtowardspubliccompanies.Asourpracticeis limitedtoprivatecompanies,wehaveconsolidatedthosehundredsofratiosintothirteenratiosthatwe believearemostappropriateforsmallandmediumsizedprivatelyheldcompanies.Theseratiosare easytocalculatefromstandardpublishedfinancialstatementsandarebestifusedovertime.Thatis, theyrevealthemostwhenlookedatinatrendoverseveralyears. www.BluePointStrategies.com

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Theinterpretationoffinancialratioscanbeskewedbytheintentionalmismanagementofacompanys financialstatements.TheCFOswhoparticipateinthissortofactivityusuallymakethenewsandhave unhappyfutures.Offeringinterpretationsintheindividualratiolistingsforsuchcaseswouldmakethis guidelongandunnecessarilycomplicated.Thisguideisofferedasatoolforsmallandmediumbusiness ownerstoevaluatetheperformanceoftheirowncompany.Theguideassumesthatmanagementis usingitsbesteffortstorunabusinessinalegalandethicalmanner.

PROFITABILITYRATIOS
Profitabilityratiosmeasureacompanysabilitytogenerateprofitsandcontrolexpenses.

GrossProfitMarginPercentage
Computation:grossprofit(revenueminuscostofgoodssold)dividedbyrevenue. GrossMargin%=GrossProfitRevenue Interpretation:GrossMargin%showstheprofitabilityofthecompanysproductsorservices themselves,withoutotheroverheadexpenses.Thisratiocanbeappliedtothecompanyasawholeor allthewaydowntoaspecificproductofSKU.Itisakeymeasureofprofitability,becauseitisdifficultto increasethegrossmarginofaproduct.Onatrendbasis,anincreaseinthegrossmarginreflectsthe companysabilitytopassalongrawmaterialincreasestothecustomerormaybeanindicationthatthey arefacinglittlecompetitionorhaveasuperiorsalesforce.Decreasinggrossmarginsindicatethatthe companyisunderseverecompetitivepressuresandishavingtoloweritspricestogeneratesalesorthat itsnotabletopassalongincreasesinrawmaterialsorlaborwageincreases.Assuch,thegrossmargin serversasanearlywarningsignalofthecompanyshealth.

OperatingProfitMarginPercentage
Computation:operatingmargin(grossprofitminusoperatingexpenses)dividedbyrevenue. OperatingMargin%=OperatingProfitRevenue Interpretation:OperatingMargin%showsthebasicprofitabilityofthecompanysbusiness,orinother words,howwellthecompanysmanagersaremanagingthebusiness.Theoperatingmargin%isbest comparedonatrendbasisandfallingornegativetrendsindicatethatexpensesareincreasingfaster thansales. www.BluePointStrategies.com

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NetProfitMarginPercentage
Computation:netprofitdividedbyrevenue. NetProfitMargin%=NetProfitRevenue Interpretation:NetProfitMargin%,alsoknownasreturnonsales,reflectsthecompanysbottomline performance.Ittellshowmuchprofitacompanygetstokeepafterpayingallthebills.Liketheother twoprofitmarginratios,itsbestconsideredinatrendandcomparedtocompaniesinasimilarindustry orindustryaveragesbycompanysize.

ReturnonAssets(ROA)
Computation:netprofitdividedbytotalassets ReturnonAssets=NetProfitTotalAssets Interpretation:Thisratioexpressesthereturnontotalassetsandmeasurestheeffectivenessof managementinemployingtheresourcesavailabletoit.Itexpressesthepercentageofeverydollar investedinthebusinessthatwasreturnedtotheownerasprofit.Italsoallowsforthecomparisonof companyperformanceacrosssizecategories.Whileahighpercentageisgood,aROAthatistoohigh mayreflectprofitsbeingstrippedfromthecompanyandnotbeingreinvestedforfutureprofits.Ifa companydoesntcontinueinvestinginnewassets,itslongrangeprofitabilitywillsuffer.

ReturnonEquity(ROE)
Computation:netProfitdividedbyShareholdersEquity ReturnonEquity=NetProfitShareholdersEquity Interpretation:Thisratioexpressestherateofreturnoninvestedcapital.Whileitcanserveasan indicatorofmanagementperformance,youarecautionedtouseitinconjunctionwithotherratios.A highreturn,normallyassociatedwitheffectivemanagement,couldindicateanundercapitalizedform. Whereas,alowreturn,usuallyanindicatorofinefficientmanagementperformance,couldreflecta highlycapitalized,conservativelyoperatedbusiness.Inanyevent,itsagoodindicationofwhethera companyiscapableofreturningaprofitthatisworththerisk.

LEVERAGERATIOS
Leverageratiosletyouseehowextensivelyacompanyusesdebt,orleverage,initsoperations. Leverageratiosrefertofinancialleverage,theextenttowhichacompanysassetsarefinancedwith debt,ascomparedtooperatingleverage,whichistheratiooffixedcoststovariablecosts.Bankerslove theleverageratios. www.BluePointStrategies.com 3|P a g e

DebttoEquity
Computation:totalliabilitiesdividedbyshareholdersequity DebttoEquity=TotalLiabilitiesShareholdersEquity Interpretation:Thisratioexpressestherelationshipbetweencapitalcontributedbycreditorsandthat contributedbyowners.Itissimpletheratioofhowmuchdebtthecompanyhasforeverydollarof shareholderequity.Thehighertheratio,thegreatertheriskbeingassumedbycreditors.Alowerratio generallyindicatesgreaterlongtermfinancialsafety.Afirmwithalowdebttoequityratiousuallyhas greaterflexibilitytoborrowinthefuture.Amorehighlyleveragedcompanyhasamorelimiteddebt capacity.

InterestCoverage
Computation:totalliabilitiesdividedbyshareholdersequity InterestCoverage=OperatingProfitAnnualInterestCharges Interpretation:Thisratiomeasuresthecompanysinterestexposure;howmuchofitsoperatingprofitis neededjusttocovertheannualinterestexpense.Aratioof1.0meansthatallthecompanysoperating profitsarerequiredjusttopaytheinterestexpense.Ahighratiogenerallymeansthatacompanycan affordtotakeonmoredebt.

LIQUIDITYRATIOS
Liquidityratiosrevealacompanysabilitytomeetitsfinancialobligationsincludingdebt,payroll,taxes andpaymentstovendors.

CurrentRatio
Computation:currentassetsdividedbycurrentliabilities CurrentRatio=CurrentAssetsCurrentLiabilities Interpretation:Thisratioisaroughindicationofafirmsabilitytoserviceitscurrentobligationsinthe shortterm.Generally,thehigherthecurrentratio,thegreaterthecushionbetweencurrent obligationsandafirmsabilitytopaythem.Aratiolessthan1.0meansthatthecompanywillrunoutof cashtomeetitsobligationsintheshortterm.Thecompositionandqualityofcurrentassetsisacritical factorintheanalysisofanindividualfirmsliquidity. www.BluePointStrategies.com 4|P a g e

QuickRatio
Computation:currentassetsminusinventorydividedbycurrentliabilities. QuickRatio=(CurrentAssetsInventory)CurrentLiabilities Interpretation:AlsoknownastheACIDTESTratio,itisarefinementofthecurrentratioandisamore conservativemeasureofliquidity.Theratioexpressesthedegreetowhichacompanyscurrent liabilitiesarecoveredbythemostliquidassets.Generally,anyvalueoflessthan1.0impliesareciprocal dependencyoninventoryorothercurrentassetstoliquidateshorttermdebt.

CashConversionCycle
Computation:daysinventoryplusdayssalesoutstandingminusdayspayables. CashConversionCycle=DaysSalesOutstanding+DaysInventoryDaysPayables Interpretation:Thecashconversioncycleisthenumberofdaysnegotiatedfinancingisneededto supporttheoperatingcycleofabusiness.Abusinesssoperatingcycleissimplythenumberofdaysits goodsaretiedupininventoryplusthenumberofdaysitssalesaretiedupinreceivables.Calculating thecashconversioncycletellsyoualotmoreaboutabilitytopaythanthequickorcurrentratio.In business,cashflowisthelifebloodofacompany.

EFFICIENCYRATIOS
Theefficiencyratiosshowhowefficientlymanagementrunscertainbasefunctionsofthecompany; inventory,collectionsandpayables.

DaysInventory
Computation:averageinventoryorendinginventorydividedbycostofgoodssoldperday DaysInventory=EndingInventory(CostofGoodsSold360) Interpretation:measureshowmanydaysofinventoryareintheproductionordistributionsystem. Inventoryflowsthroughacompanyssystematafasterorslowerrate,howfastismovesisan indicationofhowquicklythecompanycanturninventoryintocash.BoththeDaysInventoryandthe Inventoryturnsmeasurehowefficientlyacompanyutilizesitsinventory. InventoryTurnsisafunctionofDaysInventoryinthatitmeasureshowmanytimesa companysinventoryturnsoverduringayear.Itiscalculatedbydividingthedaysinventorinto360. Inventoryturns=360DaysInventory www.BluePointStrategies.com 5|P a g e

DaysSalesOutstanding(DSO)
Computation:endingA/Rdividedbyrevenueperday DaysSalesOutstanding=EndingA/R(Revenue360) Interpretation:DSOisameasureofhowquicklyacompanyscustomerspaytheirbills.Generally,the greaternumberofdaysoutstanding,thegreatertheprobabilityofdelinquenciesinaccountsreceivable. Acomparisonofacompanysdailyreceivablesmayindicatetheextentofacompanyscontrolover creditandcollections.Thetermsofferedbyacompanytoitscustomers,howevermaydifferfrom termswithintheindustryandshouldbetakenintoconsideration.

DaysPayablesOutstanding(DPO)
Computation:endingA/Pdividedbycostofgoodssoldperday DaysPayablesOutstanding=EndingA/P(CostofGoodsSold360) Interpretation:Thisfigureexpressestheaveragetimeindaysthatittakesacompanytopayitsvendors. Generally,thehigherthenumber,themorecashacompanyiskeepingonhand.However,thecompany hastostrikeabalancebetweenpreservingcashandkeepingvendorshappy.

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