Gain valuable insight into your business with ratio analysis

Gain valuable insight into your business with ratio analysis Valuation experts regularly use financial ratio analysis to evaluate the financial health of a company. These financial ratios are calculated from line items in a company’s financial statements and are useful in examining historical trends and gaining insight into how a business is likely to perform in the future. A ratio analysis can help gauge a company’s ability to meet its current liabilities and finance future growth, how well the company is using its assets, or how its profitability compares with that of its industry peers. There are four principal categories of ratios: Liquidity ratios measure the ability of a company to meet current obligations. Commonly used liquidity ratios include: • Current ratio, or the ratio of current assets to current liabilities, • Quick ratio, which only considers assets that can be readily liquidated, such as cash and accounts receivable, and • Receivables turnover, which estimates the average collection period for credit sales. Since current assets are generally used to pay short-term debt and make interest payments, it’s essential that a company have adequate current assets. Liquidity ratios illustrate a company’s need to improve liquidity or make more efficient use of its funds. Coverage ratios measure a company’s capacity to service its debt. One commonly used coverage ratio is times interest earned, which measures a firm’s ability to meet interest payments and indicates its capacity to take on additional debt. Another is current debt coverage, which can be used to measure a company’s ability to repay its current debt. Before a company that already has significant bank debt seeks further financing, it should calculate its coverage ratios and consider what message they send to potential lenders. Leverage ratios can indicate the long-term solvency of a company. The long-term debt-to-equity ratio represents how much debt financing is funding company assets. For example, a ratio of one-to-one indicates that the company’s operations may be meeting most of its capital requirements, and that debt financing is not a material source of capital. Because cash isn’t necessarily needed to service debt, there may be more available for potential shareholder distributions. On the other hand, a long-term debt-to-equity ratio of five-to-one indicates that the company requires significant debt financing to run operations. This may translate into lower returns for shareholders and higher default risk for creditors. And, because the company needs to make considerable interest payments, it has less cash to meet its current obligations. Operating ratios help appraisers evaluate a number of things, including management’s performance and the effects of economic and industry forces. Operating ratios can illustrate how efficiently a company is controlling costs, generating sales and profits, converting revenues to cash, and using its fixed assets. Benchmark company performance Since ratio performance can vary from industry to industry, ratio results mean little without appropriate benchmarks. Benchmarking a company to its competitors, its industry averages and its own historical performance provides perspective on its current financial health. Valuation experts find information on appropriate benchmarks from rating agencies like Dun & Bradstreet, government sources such as the Securities and Exchange Commission, and industry trade associations. They also apply current ratios to the company’s historical financial statements. This helps identify positive trends to be maintained and negative trends that need to be addressed. Basic understanding goes a long way Ratios provide valuators with valuable insight into a company’s financial performance and health. A basic understanding of these ratios will also help owners and management make better, more-informed decisions about their company’s financial future. If you would like to speak with one of our Business Valuation advisors, please contact John Gurley, jgurley@bdmp.com, (207) 775-2387; or Art Marshall, amarshall@bdmp.com, (603) 669-7337.