Using the Statements to Measure Financial Health
The financial statements tell different but related stories about how well your company is doing financially:
• The income statement shows the bottom line. Using the rules of accounting, it indicates how much profit or loss a company generated over a period of time—a month, a quarter, or a year.
• The balance sheet shows whether a company is solvent. It provides a snapshot of the company’s assets, liabilities, and equity on a given day.
• The cash flow statement shows how much cash a company is generating. It also tracks, in broad terms, where that cash came from and what it is being used for.
Now you’re ready to take the next step: interpreting the numbers these statements provide. For example, is the company’s profit large or small? Is its level of debt healthy or unhealthy? You can answer such questions through ratio analysis.
A financial ratio is just two numbers from the financial statements expressed in relation to each other. The ratios that follow are useful for almost any industry. But if you want to gauge your own company’s performance, the most meaningful comparison is usually with other companies in the same industry.
Profitability ratios
Profitability ratios help you evaluate a company’s profitability by expressing its profit as a percentage of something else. They include:
• Return on sales (ROS), or net income divided by revenue. (Remember that net income on the income statement just means profit.) Also known as net profit margin, ROS measures how much profit the company earns as a percentage of every sales dollar. For example, if a company makes a profit of $10 for every $100 in sales, the ROS is 10/100, or 10%.
• Return on assets (ROA), or net income divided by total assets. (You can find total assets on the balance sheet.) ROA indicates how efficiently the company is using its assets to generate profit.
• Return on equity (ROE), or net income divided by owners’ equity. ROE shows how much profit the company is generating as a percentage of the owners’ investment.
• Gross profit margin, or gross profit divided by revenue. This ratio reflects the profitability of the company’s products or services without considering overhead or other expenses.
• Earnings before interest and taxes (EBIT) margin, or operating profit divided by revenue. Many analysts use this indicator, also known as operating margin, to see how profitable a company’s operating activities are.
You can use these ratios to compare one company with another and to track your own company’s performance over time. A profitability ratio that is headed in the wrong direction is usually a sign of trouble.
Efficiency ratios
Efficiency ratios show you how efficiently a company is managing its assets and liabilities. They include:
• Asset turnover, or revenue divided by total assets. The higher the number, the better a company is at employing assets to generate revenue.
• Days sales outstanding, or ending accounts receivable (from the balance sheet) divided by revenue per day (annual revenue divided by 360). This ratio tells you how long (on average) it takes a company to collect what it’s owed. A company that takes 45 days to collect its receivables needs significantly more working capital than one that takes 20 days to collect.
• Days payable outstanding, or ending accounts payable divided by cost of goods sold per day. This measure tells you how many days it takes a company to pay its suppliers. The more days it takes, the longer a company can use the cash. Of course, the desire for more cash has to be balanced against maintaining good relationships with suppliers.
• Inventory days, or average inventory divided by cost of goods sold per day. This ratio indicates how long it takes a company to sell the average amount of inventory on hand during a given period of time. The longer it takes, the more cash the company has tied up and the greater the likelihood that the inventory will not be sold at full value.
Again, it’s often helpful to compare changes in these ratios from one period to the next, and to track trends in the ratios over three years or more.
Liquidity ratios
Liquidity ratios tell you about a company’s ability to meet current financial obligations such as debt payments, payroll, and vendor payments. They include:
• Current ratio, or total current assets divided by total current liabilities. This is a prime measure of a company’s ability to pay its bills. It’s so popular with lenders that it’s sometimes called the banker’s ratio. Generally speaking, a higher ratio indicates greater financial strength than a lower one.
• Quick ratio, or current assets minus inventory, with the result divided by current liabilities. This ratio is sometimes called the acid test. It measures a company’s ability to deal with its liabilities quickly without having to liquidate its inventory.
Lenders aren’t the only stakeholders who scrutinize liquidity ratios. Suppliers, too, are likely to inspect them before offering credit terms.
Leverage ratios
Leverage ratios tell you how, and how extensively, a company relies on debt. (The word leverage in this context means using debt to finance a business or an investment.)
• Interest coverage, or earnings before interest and taxes (EBIT) divided by interest expense. This measures a company’s margin of safety: It shows how many times over the company could make its interest payments from its operating profit.
• Debt to equity, or total liabilities divided by owners’ equity. This shows how much a company has borrowed compared with the money its owners have invested. A high debt-to-equity ratio (relative to other companies in the industry) is sometimes a reason for concern; the company is said to be highly leveraged.
Nearly every company borrows money at some point in its life. Like a household with a mortgage, a company can use debt to finance investments that it other wise couldn’t afford. The debt becomes a problem only when it’s too high to be supported.
Other ways to measure financial health
Other methods of assessing a company’s financial health include valuation, Economic Value Added (EVA), and measurements of growth and productivity. Like the ratios just discussed, these measures are most meaningful when you are comparing companies in the same industry or looking at one company’s performance over time.
Valuation usually refers to the process for determining the total value of a company. The book value is simply the owners’ equity figure on the balance sheet. But the market value of the business—what an acquirer would pay for it—may be quite different.
Publicly traded companies can measure their market value every day: They just multiply the daily stock price by the number of shares outstanding. A privately held company—or someone who is considering buying one—must estimate its market value. One method is to estimate future cash flows and then use some interest rate to determine how much that stream of cash is worth right now. A second method is to evaluate the company’s assets—both physical assets and intangible assets such as patents or customer lists. A third is to look at the market value of publicly traded companies that are similar to the company being evaluated.
Of course, a company may be worth different amounts to different buyers. If your employer owns a unique technology, for instance, an acquirer that wants that technology for its operations may be willing to pay a premium for the business.
ANALYZING FINANCIAL STATEMENTS
• Compare numbers with what’s typical in a given industry.
• Compare statements of similar-sized companies.
• Watch for trends: How have the statements changed since last year? From three years ago?
Valuation also refers to the process by which Wall Street investors and stock analysts determine what a publicly traded company “ought” to be selling for (in their view). That helps them decide whether the current market price of the stock is a good deal or a bad one. Analysts and investors use various gauges in this process, including:
• Earnings per share (EPS), or net income divided by the number of shares outstanding. This is one of the most commonly watched indicators of a company’s financial performance. If it falls, it will most likely take the stock’s price down with it.
• Price-to-earnings ratio (P/E), or the current price of a share of stock divided by the previous 12 months’ earnings per share.
• Growth indicators, such as the increase in revenue, earnings, or earnings per share from one year to the next. A company that is growing will probably provide increasing returns to its shareholders over time.
• Economic Value Added (EVA). A registered trademark of the consulting firm Stern, Stewart, EVA indicates a company’s profitability after a charge for the cost of capital is deducted. The calculation is quite technical.
• Productivity measures. Sales per employee and net income per employee are two measures that link revenue and profit to workforce data. Trend lines in these numbers may suggest greater or lesser operating efficiency over time.
Wall Street loves statistics, and these are just a few of the indicators that the professionals use. But they are among the most common.