Jan 14 2019
What do investing, auditing, determining business valuation and even procurement have in common? These functions all require meticulous analysis of financial information. The trouble is that a company’s financial statements contain an incredible amount of numbers and figures, which can easily lead to confusion and intimidation.
Enter: Financial ratios
Financial ratios are comparative measures – usually expressed as a percentage – used to assess the financial health of a company. The metrics used are taken from a company’s financial statements, primarily the income statement and the balance sheet. Financial ratios convert financial information to a standardized format so companies can easily be compared against each other as well as the broader industry.
Financial ratios are used across many different industries, including accounting, business valuation, banking, procurement and consulting. Professionals within these industries use financial ratios to identify red flags and areas of concern, tailor projections (such as cash flow and share performance), analyze credit, assess risk, and strategize, among many other things.
The Most Important Financial Ratios
While there are many financial ratios, they broadly fall into four main categories: Liquidity, Profitability, Leverage and Efficiency.
Liquidity ratios shed light on a company’s ability to meet its short-term obligations to have access to cash if needed.
Think of it this way: a company that does not have enough liquidity (i.e. quick access to cash) to pay its short-term liabilities would have to sell its assets at unfavorable prices and conditions to raise money. Some of those unfavorable prices and conditions include selling an asset at below market value, borrowing at high interest rates, or selling part of the company.
A few Liquidity ratios to consider include:
Liquidity ratios include: Current Ratio, Quick Ratio, Trade Receivables Turnover and Cost of Sales
Profitability ratios highlight a company’s ability to generate profit relative to its expenses. For most of the ratios within this category, companies that display higher values relative to their competitors are performing well.
A few Profitability ratios to consider include:
Profitability ratios include: Return on Equity (ROE), Return on Assets (ROA) and Profit Margin
Leverage ratios focus on the long-term health of a company relative to its capital in the form of debt. Leverage ratios are important when assessing the financial health of a company precisely because companies rely on a mixture of equity and debt to finance their operations.
Leverage ratios to consider include:
Leverage ratios include: Fixed Assets/Net Worth and Debt/Net Worth
Efficiency ratios reflect a company’s efficiency at using its assets and resources to manage its liabilities. While there are several efficiency ratios, they are all similar because they measure the time required to generate cash from liquidating inventory.
Efficiency ratios to consider include:
Efficiency ratios include: Asset Turnover, Inventory Turnover and Days' Sales Turnover
Financial Ratios with IBISWorld
The use of financial ratios in business is of paramount importance. IBISWorld clients may have access to industry financial ratios that can be used to benchmark companies against an industry average.
Our US industry reports feature all the ratios mentioned above and more, such as assets and liabilities. Within the financial ratios table, there is data for the past three years and the current year is disaggregated by size of business. There is also scope to download historical figures back to 2007 into Excel for further analysis, allowing you to compare and benchmark the historical performance and trends within the industry.
IBISWorld's US Industry Research Reports contain extensive financial ratio calculations
How to Apply Financial Ratios
To truly understand the importance of using financial ratios, it is best to see them in action. While many industries use financial ratios, let’s focus on procurement.
The underlying success of a procurement department lies in the strength of its supply chain. In turn, the strength of the supply chain is directly correlated to the risk assessment skills of the procurement team. This is where the use of financial ratios comes into play, because assessing the financial health of an incumbent or potential supplier can make or break your supply chain. When assessing a supplier, the procurement function looks at several financial ratios across the broad financial ratio groups.
Example of Ratios in Action
A procurement department is in the process of reassessing their Packaging and Labeling Services provider. The companies they are considering include Sonoco Products (SON) and Packaging Corporation of America (PKG). In this instance, the procurement analyst decides to look at the companies’ current ratios.
The current ratio sits within the Liquidity ratio group. It measures a company’s ability to pay off its short-term debts with its current assets. Put more simply, this ratio is an indicator of how quickly a supplier can convert its assets into cash.
Current Ratio = Current Assets / Current Liabilities
Current assets are those that can be turned into cash in less than a year, such as accounts receivable, inventory and any other liquid assets. Current liabilities include wages, taxes payable and accounts. To calculate a company’s current ratio, you must divide current assets by current liabilities:
The current ratios for SON and PKG are calculated as follows for the fiscal year ended 2017:
In addition to the current ratio, the procurement professional would also assess the companies’ days’ receivables ratio. This ratio expresses the average number of days that receivables are outstanding. In general, the greater the number of days outstanding, the greater the probability of delinquencies in accounts receivables.
According to the Ratio Parameters above, SON has a greater ability to meet short-term obligations and could be considered the more sustainable supplier of the two. However, the current ratio does not tell the complete picture, but only provides a snapshot of a supplier’s liquidity.
This is where the skill of the procurement professional comes into play because when using the current ratio, it is important to determine the type of current assets the company has and how quickly they can be converted into cash to meet current liabilities. For example, how quickly can a company collect its accounts receivables?
Days’ Receivables = 365 / (sales/receivables)
The days’ receivables ratio for SON and PKG as at the end of financial year 2017 are as follows:
Nevertheless, how does Sonoco Products and Packaging Corporation of America’s current and days’ receivables ratios size up against the industry average? SON’s average number of days that receivables were outstanding was 52.9. Meanwhile, PKG’s financial statements expressed a figure of 46.8. Taken in conjunction with the current ratio and suddenly the pendulum swings back to PKG as a more suitable potential supplier.
However, there are several other financial ratios that must be taken into consideration to develop a fuller view of the financial health of the two companies. The procurement professional should also consider reviewing the debt service P&I coverage, net worth and fixed assets to net worth ratios as well.
Using IBISWorld’s information, the analyst can benchmark the companies against the industry average to provide greater context into their financial health and performance.
As you can see from our example, it is imperative that the procurement professional assessing these suppliers look at a broader range of financial ratios between the companies and benchmark that information against the industry average. Doing so ensures you’re getting a fuller picture and making the most informed decision to deliver greater value to your business.
Whether you’re investing, lending, contracting or procuring, without reviewing all available information and boiling it down to standard ways to compare, you could be missing key indicators about the financial health of the company and the industry. Benchmarking the companies against the industry average shines a brighter light on their financial health.
While SON exhibits a current ratio within reason, the company’s days’ receivables ratio is extremely elevated when compared with the industry average. Meanwhile, PKG has both an elevated current ratio and days’ receivables ratio. An analyst should examine these differences thoroughly and use additional ratios to make a better-informed business decision.
IBISWorld has been a trusted partner for business professionals across a range of industries for close to 50 years. Our collection of the latest, most up-to-date industry information, coupled with industry financial ratios, can be used across many different roles to provide you with the information necessary to make better business decisions.