Which financial ratio is the most important to you in analyzing financial statements?

  1. Working Capital Ratio
  2. Quick Ratio 
  3. Gross Margin Percentage
  4. Profit Margin Percentage
  5. Inventory Turnover Rate

We credit professionals are finding that in these tough times it might become necessary to request the financial statements from some of our customers, especially those that occupy a large percentage of our sales. Although a difficult request to make, it perhaps can’t be avoided. 

But once we have them, knowing how to evaluate the information is the next challenge. To be perfectly honest, when I hear the term “financial ratio,” I have to prepare myself for putting on my thinking cap. It’s probably the initial apprehension that I’m working with numbers outside of my comfort zone. However, after reminding myself of what they are and how they can give me a better perspective of a client’s financial strength or weakness, I greatly appreciate their usefulness. Following below are my top five financial ratios for your consideration.  

1. Working Capital Ratio (also known as the Current Ratio) – Working capital represents a company’s ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since creditors can measure a company’s ability to pay off its debts within a year.

Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining the proper category for the vast array of assets and liabilities on a corporate balance sheet and deciphering the overall health of a firm in meeting its short-term commitments.

So, if XYZ Corp. has current assets of $8 million, and current liabilities of $4 million, that’s a 2:1 ratio —which is pretty sound. But if two similar companies each had a 2:1 ratio, but one had more cash among its current assets, that firm would be better able to pay off its debts more quickly than the other.

2. Quick Ratio (also known as the Acid Test) – This ratio subtracts inventories from current assets, before dividing that figure by liabilities. The idea is to show how well current liabilities are covered by cash and by items with a ready cash value. Inventory, on the other hand, can take time to sell and convert into liquid assets.

If XYZ has $8 million in current assets minus $2 million in inventory over $4 million in current liabilities, that’s a 1.5:1 ratio. Companies like to have at least a 1:1 ratio here, but firms with less than that may be acceptable because it means they are turning their inventories over relatively quickly.

3. Gross Margin – A gross margin percentage represents how much of a company’s sales revenue it keeps after incurring any direct costs associated with producing its goods and services. This ratio is the percentage of sales revenue available for profit after the cost of goods sold (CGS) is deducted. If a company has a gross margin of 40%, that means it keeps 40 cents for every dollar it makes, and it uses the remainder towards operating expenses.

4. Profit Margin – A profit margin percentage is one of the most common ratios used to determine the profitability of a business. It shows the profit per sale after all other expenses are deducted. Furthermore, it indicates how many cents a company generates in profit for each dollar of sale. If Company X reports a 35% profit margin, that means its net income was 35 cents for every dollar generated.

5. Inventory Turnover Ratio – Inventory turnover is the rate at which a company replaces inventory in a given period due to sales. Calculating inventory turnover helps businesses make better pricing, manufacturing, marketing, and purchasing decisions. Well-managed inventory levels show that a company’s sales are at the desired level, and costs are controlled. In addition, the inventory turnover ratio is a measure of how well a company generates sales from its inventory. The inventory turnover ratio equals Cost of Goods Sold / Average Inventory. 

There are two basic inventory turnover rate results to consider: 

  • The higher the inventory turnover, the better, since high inventory turnover typically means a company is selling goods quickly, and there is considerable demand for their products. If a company has a turnover of 6 times, that means that during the year, the entire inventory is being sold off 6 times during the year, or once every two months. 
  • The lower the inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products. If a company has a turnover of .3 times, that means that during the year, only one third of the inventory is being sold, and it would take three years for all of it to be sold off. 

Of course, there are many more financial ratios which could continue to slice and dice the customer’s financial status into a variety of ways. For the time being, I believe the above will definitely get you started. 

Your thoughts and comments (nseiverd@cmiweb.com) are most welcome!

Source: Investopedia

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