Financial Ratios & Other Financial Analysis Tools
Coverage RatiosExpense to Revenue RatiosLeverage RatiosLiquidity Ratios |
Operating Ratios & IndicatorsRatio Fusion!(Altman's Z-Score for Privately Held Firms) |
Banks often use ratios in loan contracts with benchmarked limits (aka 'Covenants').
Even if covenants are not listed in your loan contract, banks still look at them.
If you include financial ratios and indicators to your financial statements, it adds credibility. (Banks and Investors) will think you use these indicators internally, and they'll love you for it!
Actually; If you're not using Financial Analysis Tools and Benchmarks internally, you should strongly consider it.
COVERAGE RATIOS:
Coverage Ratios measure the Company’s ability to meet certain obligations and/or the Company’s ability to generate earnings over and above certain expenses or fixed costs.
- Times Interest Earned: Also called the Interest Coverage ratio:
Net Income
Interest Expense.
- Debt Coverage Ratio: This ratio measures the Company’s ability to pay its short-term
debt with cash generated from Operations:
Net Income + Non-cash Expenditures
Current Portion of Long-term Debt:
(Net Income + Non-cash Expenditures) is a good estimate of how much cash was generated from Operating Activities.
- Debt Service Coverage Ratio (DSCR): This is a more detailed measure of (cash available
for debt service):
Annual Net Income + Non-cash Expenditures + Interest Expense + Discretionary Expenses
Principal Repayment + Interest payments + Lease payments
A DSCR of less than 1.0 could indicate that cash-flow is negative - that the company can't meet it's short-term obligations.
Practically every bank in the country uses this ratio as an indicator of liquidity and/or viability. It's an important ratio to know, understand, and use.
EXPENSE TO REVENUE RATIOS
Expense to Revenue Ratios are also referred to as Common-Size Analysis. Expenses are expressed as a percentage of total sales. Common-Size Analysis is a very common tool used to compare a company’s activity with prior year activity, with other companies, and with industry averages.
- % Depreciation and Amortization
Revenue
This measures the typical non-cash expense items to total sales.
Revenue
This is a very important item to note for privately held company’s because; this Percentage can vary widely from one company to another; and it directly effects Net Income. IE: If Officer’s Compensation is 35% of Sales and Net Income was at a 2% loss, it may be wrong to assume that the Company is not profitable.
LEVERAGE RATIOS
Leverage ratios attempt to measure either the effectiveness or the extent of a Company’s use of certain assets, liabilities or investments. Leverage ratios vary greatly from one industry to another, so they are more effectively understood when compared to industry standards.
- Fixed Asset Leverage Ratio: Comparing the Company’s Tangible net worth (equity less intangible
assets) to the book value of fixed assets will indicate if the Company is heavily invested in fixed assets:
Net Fixed Assets
Tangible Net Worth
Falling below industry standards could indicate that the company needs to upgrade its equipment, or that the Company re-invests a higher level of earnings than other Companies in the industry.
*Use our Rule-of-Thumb Valuation App to estimate the value of your company.*
- Debt to Equity: Also referred to as 'Debt to Tangible Net Worth':
Total Liabilities
Tangible Net Worth
A high Debt to Equity Ratio may indicate that the Company is having a hard time meeting its obligations.
- Long Term Debt to Equity: Also referred to as 'Debt to Tangible Net Worth':
Long-Term Liabilities
Tangible Net Worth
As with Debt to Equity Ratio; a high Long-Term Debt-to-Equity Ratio may indicate that the Company is having a hard time meeting its obligations.
A low Debt to Equity Ratio can suggest tht the company is not leveraging debt effectively.
*Use our Rule-of-Thumb Valuation App to estimate the value of your company.*
LIQUIDITY RATIOS:
Liquidity ratios indicate the company’s ability to meet its short term obligations.
- Current Ratio:
Current Assets
Current Liabilities
If current assets are greater than current liabilities, the current ratio will be greater than 1.0.
- The Acid Test Ratio compares Current Liabilities to Current Assets that can be quickly converted to cash. Here is an example of a
formula for an acid test ratio:
Cash + Cash Equivalents + Short-Term (liquid) investments + Accounts Receivable
Current Liabilities
A ratio of 1.0 or higher is generally considered a good score, but this is relative to the industry your company is in.
- Average Collection Period: This is an estimate of how many days it takes the Company to collect
Accounts Receivable:
Annual Revenue
Average Accounts Receivable
(Then restate the result in terms of days.)- If Annual Sales / AR = 4, then the Average Collection Period is 90 days:
360 days / 4 = 90 days.
This ratio can indicate the Companies efficiency in making collections and/or its customer satisfaction (among other things) when it is compared to industry standards.
The Average Collection Period and Revenue/Accounts Receivable are also considered to be Activity Ratios. Other activity ratios include Inventory Turnover (or COGS / Inventory), Payables Turnover, and Revenue/Working Capital.
OPERATING RATIOS and INDICATORS
Operating ratios typically focus attention on some aspect of Earnings or Sales in order to draw a conclusion about the Company’s ability to generate income.
- Fixed Asset Turnover Ratio: This ratio measures how much Sales are being generated in
relation to the Company’s investment in Fixed assets:
Sales
Fixed Assets.
This ratio should be compared to industry standards. The results can be very different from one industry to another. - Total Asset Turnover Ratio: This ratio is similar, in concept, to the
Fixed Asset Turnover Ratio, except Total Assets are used as a comparison:
Sales
Total Assets.
A ratio of 7 could be good, or it could be problematic; it depends on what industry you're in. - E.B.I.T.D.A.:
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
This is supposed to measure the companies ability to generate cash-flow to pay it's obligations. I think banks like this indicator because it's fun to say "EBITDA".
Go ahead, say it. "EBITDA" That was fun, wasn't it?!
- Gross Profit Margin: This ratio measures what percentage of each sale is applied toward Gross
Profit:
(Sales - Cost of Goods Sold)
Sales.
In theory; The Gross Profit Margin expresses the portion of marginal sales that will be added to net income before taxes, after the Company has generated enough sales to cover fixed costs and overhead. To measure the companies true profit margin, you would have to isolate ALL variable costs - not just Cost of Goods Sold. In addition, some COGS may be fixed in nature. - EBT/Tangible Net Worth:
Earnings Before Taxes
Tangible Net Worth
This Ratio measures the Pre-tax earnings as a percentage of how much shareholders have invested in the Company. Publicly traded companies more often use Return on Equity and Earnings per share to express this concept.
*Use our Rule-of-Thumb Valuation App to estimate the value of your company.* - EBT/Total Assets:
Earnings Before Taxes
Total Assets
This Ratio measures pretax earnings in comparison to total assets.
RATIO FUSION!
Lenders and financial analyst will often select a list of ratios and assign a relative point value to each one. This is done to attempt an objective assessment of a particular company.
One of my favorite analytical tools of this type is the Altman's Z-score for Privately Held Firms - A variation of the original Z-score formula developed by Dr. Edward I. Altman in 1968.
- ALTMAN'S Z-SCORE for Privately Held Firms: This series of ratios is used to predict a bankruptcy up to 2 years before it happens.
This widely accepted tool adds the results of 5 financial ratios. The resulting total is used to to assess the company's financial viability
as a going concern:
- Right-size the company based on your current market share and an honest assesment of what the company is capable of in the future.
- Create a new business plan and seek an infusion of capital.
- Quietly sell the Company's assets, pay bonuses to your Senior Directors, and stick it to the minority shareholders by leaving them with nothing.
Working Capital#/ Total Assets.
Retained Earnings / Total Assets.
Earnings Before Interest and Taxes / Total Assets.
Market Value of Equity*/ Book value of Total Debt.
Net Sales / Total Assets.
Add the results of these 5 ratios together.
The resulting total is then assessed based on a pre-determined scale, and based on the industry you are in:
| Non-manufacturing | Manufacturing | Manufacturing: Publicly traded |
|
| Bankrupt | Less than 1.1 | Less than 1.23 | Less than 1.81 |
| Zone of Ignorance | 1.1 to 2.6 | 1.23 to 2.9 | 1.81 to 2.99 |
| Non-Bankrupt | Greater than 2.6 | Greater than 2.9 | Greater than 2.99 |
If your company is in the 'Zone of Ignorance', you should contact a CPA to discuss your options.
Here are some options you may consider:
Enron, Planet Hollywood, Metatek, First Americable, Baileys Plastics, etc..
Current Assets - Current Liabilities = Working Capital.
*Use our Rule-of-Thumb Valuation App to estimate the value of your company.*
