Understand Your Business’s Value Better With Financial Ratios
There are numerous metrics used in the process of conducting a business valuation. One such metric is the financial ratio analysis. The financial ratio analysis utilizes line-items from your financial statements to understand the company’s profitability, efficiency, liquidity, and solvency. This technique is valuable because it can illustrate how a company has been performing and changing over the years and how it compares to other companies within the same industry. Ratios can also be used to predict future performance through the observation of trends and similarities.
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4 Financial Ratios You Should Know
Many ratios have more than one name. Luckily, their names are often descriptive of what is being measured. However, there is also no standardized way to calculate ratios. Meaning, there may be more than one way to calculate a particular ratio. While these are often slightly different, they remain very similar in nature.
Profitability ratios demonstrate how well a company can generate profits from its operations. Examples of these ratios include pretax earnings to total assets (similar to return on total assets), gross profit percentage (or margin), operating profit percentage (or margin), pretax earnings to sales, and pretax earnings to total equity (similar to return on equity).
Efficiency ratios, also called activity ratios, illustrate how well a company can use its assets and liabilities to generate revenue. Some of these ratios include total asset turnover, age of receivables, sales to working capital (or working capital turnover), age of inventory, and sales to net fixed assets (or fixed asset turnover).
Liquidity ratios measure a company’s ability to pay off its short-term obligations with their current assets. Two examples of these ratios are the current ratio (or working capital ratio) and the quick ratio (or acid test ratio). The quick ratio and current ratio are very similar, however, the quick ratio is considered more conservative than the current ratio. Unlike the current ratio which includes all assets as short-term debt coverage, the quick ratio only utilizes a company’s most liquid assets, i.e. cash & equivalents, marketable securities, and accounts receivable.
Solvency ratios, also called leverage ratios, evaluates the ability of a company to stay afloat, or avoid bankruptcy, over the long-term by paying off their long-term debt and interest. These ratios compare a company’s debt levels with their assets, equity, and earnings. Debt to equity and times interest earned are examples of these ratios. Times interest earned, for instance, measures how many times a company can cover its interest with their earnings.
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How To Use Financial Ratios
Since the makeup of financial statements is often wildly different across industries, there are typically no generally accepted outcomes from these ratios. As a result, ratios must be compared within the same industry and sector to best evaluate their meaning. One measured ratio could be great in the automotive industry, but horrible in the consumer staples industry. Additionally, a single ratio cannot provide the entire story of a company’s performance. Multiple ratios from the same group must be used to determine the true health of a company in that respective area.
How does this information help you and how does Rea & Associates fit into the picture? For starters, understanding these ratios and how to improve them will help you enhance your business in each of the four areas mentioned above. In turn, these improvements will subsequently increase the value of your business. Rea will help you analyze these ratios and form an action plan. You will be able to see the results with a valuation of your business done before and after the plan is implemented.
If you, or someone you know, requires a business valuation for estate, gift, litigation, merger and acquisition, or business planning purposes, please contact Rea & Associates to learn more about our services.
By Duncan Copeland, Valuation and Transaction Advisory Services (Dublin office)