Question

Recommend ways in which management can improve a firm’s financial performance? recommendations should lead to increase in ROE and/or market value ratios trough business improvements rather than mechanical statements like reduce total equity.

Answer 1

A common use of financial ratios is when a lender determines the stability and health of your business by looking at your balance sheet. The balance sheet provides a portrait of what your company owns or is owed (assets) and what it owes (liabilities). Bankers will often make financial ratios a part of your business loan agreement. For instance, you may have to keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities.

But ratios should not be evaluated only when visiting your banker. Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company. Although there are different terms for different ratios, they fall into 4 basic categories.

Liquidity ratios

what constitutes a healthy ratio varies from industry to industry. For example, a clothing store will have goods that quickly lose value because of changing fashion trends. Still, these goods are easily liquidated and have high turnover. As a result, small amounts of money continuously come in and go out, and in a worst-case scenario liquidation is relatively simple. This company could easily function with a current ratio close to 1.0.

On the other hand, an airplane manufacturer has high-value, non-perishable assets such as work-in-progress inventory, as well as extended receivable terms. Businesses like these need carefully planned payment terms with customers; the current ratio should be much higher to allow for coverage of short-term liabilities.

Efficiency ratios

Assessing your inventory turnover is important because gross profit is earned each time such turnover occurs. This ratio can enable you to see where you might improve your buying practices and inventory management. For example, you could analyze your purchasing patterns as well as your clients to determine ways to minimize the amount of inventory on hand. You might want to turn some of the obsolete inventory into cash by selling it off at a discount to specific clients. This ratio can also help you see if your levels are too low and you're missing out on sales opportunities.

Inventory to net working capital ratio can determine if you have too much of your working capital tied up in inventory. It is calculated by dividing inventory by total current assets. In general, the lower the ratio, the better. Improving this ratio will allow you to invest more working capital in growth-driven projects such as export development, R&D and marketing.

Profitability ratios

A common analysis tool for profitability ratios is cross-sectional analysis, which compares ratios of several companies from the same industry. For instance, your business may have experienced a downturn in its net profit margin of 10% over the last 3 years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is performing relatively well. Nonetheless, you will still need to analyze the underlying data to establish the cause of the downturn and create solutions for improvement.

Leverage ratios

These ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business.

Debt-to-equity and debt-to-asset ratios are used by bankers to see how your assets are financed, whether it comes from creditors or your own investments, for example. In general, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities.

Accessing and calculating ratios

To determine your ratios, you can use a variety of online tools such as BDC's ratio calculators, although your financial advisor, accountant and banker may already have the most currently used ratios on hand.

For a fee, industry-standard data is available from a variety of sources, both printed and online, including Dun & Bradstreet's Industry Norms and Key Business Ratios, RMA's Annual Statement Studies and Statistics Canada (search for Financial Performance Indicators for Canadian Business). Industry Canada's SME Benchmarking Tool offers basic financial ratios by industry, based on Statistics Canada small business profiles.

Interpreting your ratios

Ratios will vary from industry to industry and over time. Interpreting them requires knowledge of your business, your industry and the reasons for fluctuations. In this light, BDC experts offer sound advice, which can help you interpret and improve your financial performance.

Beyond the numbers

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. Regional differences in factors such as labor or shipping costs may also affect the result and the significance of a ratio. Sound financial analysis always entails closely examining the data used to establish the ratios as well as assessing the circumstances that generated the results.

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