Financial ratios are the cornerstone of any company valuation. Analysts, investors, creditors, and all other lending institutions rely on these ratios to gauge a company’s footing in the business. In this article, we will explore the idea of financial ratios with a deeper insight into some of the basic types of ratios. We have also compiled a comprehensive database of the IRS financial ratios by industry which will act as quick reference for your respective businesses.
FINANCIAL RATIOS FOR COMPANY VALUATIONS
The performance of a business is ultimately reflected in their periodic financial statements. As important as they are as a document, the numbers in these statements alone are not capable of indicating any underlying issues, risk trends, or a probable future performance, unless they are analyzed properly. Let us explore this further.
WHAT ARE FINANCIAL RATIOS?
In simple terms, financial ratios are the relationship established between various statistical data provided in the company’s financial documents such as the balance sheet, income statement, cash flow statements, etc. These ratios are derived by dividing one financial measurement by the other.
Financial ratios serve as an important tracking tool for identifying trends and discrepancies in the company’s finances. This helps management spot problematic areas in the very early stages. However, considering a stand-alone ratio can be misleading. A competent financial analyst will refer to a good mix of ratios before arriving at any conclusion.
Financial ratios are primarily used by two categories of people:
- Within the company: Founders, management team, and employees.
- Outside the company: Financial analysts, security analysts, competitors, investors, creditors, tax and regulatory authorities.
KEY FINANCIAL RATIO TYPES
Of the many financial ratios used, this section provides a snapshot of the four basic ones. A basic comparison of your company figures with those of your competitors’ will provide a quick insight into your business performance.
Liquidity ratio indicates the cash availability in the business. This in turn determines the company’s ability to pay back short-term liabilities, accounts payable, among other debts.
- Current ratio = Current assets/current liabilities
- Acid-test ratio = Current assets – Inventories/Current liabilities
- Cash ratio = Cash and Cash equivalents/Current liabilities
- Operating cash flow ratio = Operating cash flow/ Current liabilities
This ratio measures the company’s income generating ability as compared to the revenue, balance sheets assets, equity, and operating costs.
- Gross margin ratio = Gross profit/Net sales
- Operating margin ratio = Operating income/ Net sales
- Return on assets ratio = Net income/ Total assets
- Return on equity ratio = Net income/ Shareholder’s equity
Efficiency Rations & Turnover Ratios
The efficiency and turnover measures the ability of the company to manage its assets and liabilities efficiently for the company. It in turn uses these company assets to turnover higher revenue.
- Annual inventory turnover ratio= Cost of good sold/average inventory
- Total Asset Turnover ratio= Net sales/ total assets
- Accounts receivable turnover ratio= Net sales / Average Accounts Receivables
- Average collection period= 365 days / Accounts Receivable turnover
- Market value ratios – These financial ratios help analyze the share price of a company. Different types of market value ratios help determine trends such as the per-share value based on available equity, the dividends shareholders will receive compared to the market value per-share, the net income earned for each outstanding shares, and the share price of the company as compared to its earning per-share.
- Leverage financial ratios – These financial ratios indicate the company’s debt levels. The various types of debt ratios help determine factors such as the amount of company assets provided through debt, weight of the total debt and financial liabilities against shareholder’s equity, the company’s ease in paying interest expenses, and the ease with which a company will pay its debt obligations.
Using Financial Ratios in benchmarking business valuations
Companies generally use certain guidelines to derive multiples. Industry benchmarks are either derived from these company-driven multiples or from credible industry benchmark databases. It is up to a financial analyst to use trend analysis, common size analysis, and ratio analysis to compare the subject company and the selected benchmarks in order to create a reliable multiple.
Common Industry Benchmark databases for Financial Ratios
- The Risk Management Association (RMA) is a member-driven non-profit that focuses on compiling financial data. They are best known for publishing meticulously curated comparative industry benchmark data reports, which is popularly known as the Annual Statement Studies®. It is the only source of financial ratio benchmarks directly derived from over 250,000 financial statements of contributing member clients. Their database is 700+ industries strong and compiles data from documents such as balance sheets, income statement line items, and close to 19 different ratios. Their database is sorted by the North American Industrial Classification System (NAICS) code and contains both national and regional data.
- BizMiner is a good reference point for industry and geographic data. Their level of detail and consistency is impressive. It is an economic development consulting database created by location using an expanded version of the NAICS system. With more than 9,000 lines of businesses and over 18 million business operations, BizMiner is one of the most accurate information metrics available today.
- The Valuation Handbook – U.S. Industry Cost of Capital published by Duff & Phelps. This handbook includes information from 170+ industries, and includes data such as the cost of equity capital, cost of debt capital, weighted average cost of capital, sales, market capitalization, capital structure, various levered and unlevered data estimates, valuation multiples, financial and probability ratios, equity returns, aggregate forward-looking EPS, and many more. An analyst can use this data as a benchmark to support their findings about the subject industry. The industries included in this book are organized by their Standard Industrial Classification (SIC) code.
- IRS financial ratios is the only source of financial ratio benchmarks created from more than 5 million corporate tax returns collected by the IRS. It provides financial statement benchmarking data of 250+ industries. This data helps an analyst benchmark the subject company against industry standards. This database includes 10 years of IRS data allowing multi-year analysis of industry trends.
IRS Financial Ratios By Industry
As we observed in the previous section, the IRS financial ratio database is the most reliable reference point. The curation of data over 10 years makes it a go-to document for in-depth industry trends. In this below table we have collated data of 200+ industries from the IRS database in a condensed format.
|Name||No. of returns||Current Ratio||Quick Ratio||Net Sales/Receivables||COGS/Payables||EBIT/Interest|
|Accounting, tax preparation, bookkeeping, and payroll services||92,774||1.13||0.38||15.73||15.24||5.06|
|Activities related to credit intermediation (loan brokers, check clearing, etc.)||15,262||1.18||1.03||1.65||0.00||3.09|
|Administrative and support services||218,315||1.49||1.24||15.52||22.03||9.34|
|Advertising and related services||46,203||0.93||0.78||3.51||1.42||2.95|
|Aerospace product and parts||1,287||1.20||0.54||6.85||5.85||5.46|
|Agriculture, construction, and mining machinery||3,017||1.31||0.93||1.48||2.34||1.96|
|Amusement, gambling, and recreation industries||50,602||1.01||0.78||12.80||3.21||4.19|
|Animal food manufacturing and grain and oilseed milling||2,147||1.02||0.33||15.63||4.21||3.20|
|Apparel accessories and other apparel||1,773||3.63||1.36||8.10||7.75||1.97|
|Apparel knitting mills||126||1.76||0.69||7.56||6.05||2.52|
|Apparel, piece goods, and notions||22,463||1.67||0.77||8.24||6.54||5.19|
|Architectural and structural metals||7,534||1.76||1.20||5.97||8.69||3.20|
|Architectural, engineering, and related services||105,277||1.42||1.08||5.56||5.46||4.25|
|Asphalt paving, roofing, other petroleum and coal products||870||1.43||0.97||8.25||7.70||3.24|
|Audio and video equipment manufacturing and reproducing magnetic and optical media||433||1.34||0.93||2.48||1.99||1.60|
|Automotive equipment rental and leasing||6,609||0.45||0.28||7.51||3.64||1.94|
|Automotive repair and maintenance||115,659||1.69||1.20||35.14||13.95||5.07|
|Bakeries and tortilla manufacturing||4,653||1.72||1.09||12.74||10.63||4.71|
|Beer, wine, and distilled alcoholic beverage||4,617||1.44||0.68||14.30||9.93||7.65|
|Beer, wine, and liquor stores||23,956||2.93||0.74||163.68||18.34||5.41|
|Beverage and tobacco product|
|Boiler, tank, and shipping container||999||1.01||0.51||6.33||3.76||1.81|
|Broadcasting (except Internet)||3,200||1.14||0.86||5.12||4.74||1.94|
|Building material and garden equipment and supplies dealers||21,939||2.19||0.99||15.87||12.59||4.56|
|Cement, concrete, lime, and gypsum product||3,456||1.75||0.92||6.88||9.58||2.27|
|Chemical and allied products||9,193||1.62||0.84||5.46||8.49||3.76|
|Clay, refractory, and other nonmetallic mineral product||2,035||2.16||1.18||6.91||7.03||2.35|
|Clothing and clothing accessories stores||48,560||1.56||0.54||30.07||6.35||6.02|
|Coating, engraving, heat treating, and allied activities||2,745||1.14||0.72||8.66||10.06||3.52|
|Combination gas and electric||261||0.78||0.42||6.01||3.17||2.03|
|Commercial and industrial machinery and equipment rental and leasing||24,965||1.83||1.49||2.43||2.58||1.56|
|Commercial and service industry machinery||1,074||1.41||0.98||3.81||3.44||2.98|
|Commodity contracts dealing and brokerage||1,938||1.04||0.49||0.39||0.00||1.52|
|Computer and peripheral equipment||1,305||0.80||0.41||5.45||2.93||5.79|
|Computer systems design and related services||143,244||1.08||0.87||6.37||4.99||4.30|
and electronic product manufacturing
|Construction of buildings||231,020||1.72||0.87||8.33||6.76||5.85|
|Converted paper product||1,609||1.20||0.68||6.93||4.65||4.97|
|Credit card issuing and other consumer credit||6,545||2.53||2.47||0.11||0.01||1.33|
|Cut and sew apparel contractors and manufacturers||6,099||1.73||0.89||10.30||7.58||6.70|
|Cutlery, hardware, spring and wire: machine shops, screw, nut, and bolt||20,820||2.21||1.32||6.50||9.29||3.01|
|Data processing, hosting, and related services||15,998||1.73||0.92||5.12||2.48||3.06|
|Database directory and other publishers||4,372||1.15||0.65||8.24||3.34||1.77|
|Drugs and druggists' sundries||7,306||1.02||0.59||8.78||0.00||4.55|
|Electric power generation, transmission, and distribution||1,558||0.86||0.50||5.88||3.86||1.57|
|Electrical and electronic goods||30,089||1.46||0.88||7.15||7.14||5.91|
|Electrical equipment, appliance, and component manufacturing||3,648||2.47||1.47||7.49||8.23||4.24|
|Electrical lighting equipment and household appliance||1,100||0.61||0.36||2.65||2.33||1.27|
|Electronic markets and agents and brokers||12,397||2.20||1.74||43.19||0.00||4.92|
|Engine, turbine, and power transmission equipment||545||1.43||0.79||3.44||6.06||3.88|
|Fabricated metal product manufacturing||30,371||2.65||1.64||7.87||12.65||5.33|
|Farm product raw material||3,392||1.58||0.79||8.24||10.42||2.97|
|Food services and drinking places||224,021||1.64||1.12||87.57||22.82||9.36|
|Food, beverage and liquor stores||75,622||1.92||0.77||76.64||21.75||7.08|
|Forestry and logging||8,720||2.30||1.57||13.24||42.88||3.33|
|Forging and stamping||1,911||2.20||1.40||6.80||8.11||3.98|
|Fruit and vegetable preserving and specialty food manufacturing||1,232||1.35||0.60||11.88||7.03||3.91|
|Furniture and home furnishings stores||28,118||1.56||0.57||16.86||7.07||6.80|
|Furniture and related product manufacturing||10,641||1.53||0.81||10.26||7.95||4.88|
|Furniture, sports, toys, recycle, jewelry, and other durable goods||73,476||1.60||0.76||9.11||7.38||4.64|
|General merchandise stores||8,464||2.30||0.69||29.10||14.40||5.89|
|Glass and glass product||1,704||1.40||0.82||6.37||6.27||2.54|
|Grocery and related product||36,570||1.17||0.72||8.69||11.64||3.68|
|Hardware, plumbing, heating equipment, and supplies||12,830||2.21||1.12||8.05||8.17||5.37|
|Health and personal care stores||48,598||1.51||0.72||16.67||10.12||5.95|
|Heavy and civil engineering construction and land subdivision||35,333||1.74||1.21||6.69||9.65||3.89|
|Home centers; paint and wallpaper stores||3,281||1.30||0.21||53.13||7.99||13.39|
|Hospitals, nursing, and residential care facilities||20,782||1.31||0.98||7.92||0.75||2.98|
|Insurance agencies and brokerages||97,133||1.02||0.87||3.11||0.11||2.74|
|Insurance carriers and related activities||91,310||1.37||1.23||8.73||0.00||5.00|
|International, secondary financing, and other nondepository credit intermediation||5,734||1.32||0.85||0.06||0.00||1.44|
|Investment banking and securities dealing||2,329||1.16||0.69||0.05||0.00||1.19|
|Iron, steel mills, and steel product||3,104||1.86||1.03||5.94||5.29||2.01|
|Lawn and garden equipment and supplies stores||8,950||1.80||0.53||26.08||10.66||5.51|
|Leather and allied product manufacturing||971||1.44||0.96||3.02||2.10||2.88|
|Lessors of buildings (including equity REITs)||261,911||1.41||0.93||1.95||0.40||1.76|
|Lessors of miniwarehouses, self-storage units, and other real estate (including equity REITs)||53,881||0.91||0.65||1.25||0.24||1.54|
|Lessors of nonfinancial intangible assets (except copyrighted works)||3,813||1.76||1.18||2.27||2.81||1.25|
|Lumber and other construction materials||15,759||2.09||1.03||9.65||11.40||3.67|
|Machinery, equipment, and supplies||46,370||1.76||0.78||7.62||7.44||4.72|
|Management of companies (holding companies)||36,507||1.04||0.88||0.04||0.00||1.36|
|Management, scientific, and technical consulting services||261,324||1.36||1.06||6.76||5.25||4.63|
|Meat and seafood processing||4,079||1.65||0.72||17.36||14.64||3.65|
|Medical equipment and supplies||8,943||1.59||1.16||2.05||2.43||2.63|
|Metal and mineral (except petroleum)||5,461||2.03||0.91||7.44||0.00||3.05|
|Metal ore mining||405||1.34||0.95||1.31||0.87||1.88|
|Miscellaneous health care and social assistance||76,703||1.49||1.18||9.40||5.45||3.14|
|Miscellaneous nondurable goods||32,079||1.19||0.64||9.11||7.14||4.58|
|Miscellaneous store retailers||74,693||1.87||0.83||15.43||8.25||3.34|
|Miscellaneous health care and social assistance||59,074||1.70||1.36||17.98||10.91||10.67|
|Motion picture and video industries (except video rental)||30,855||1.80||0.98||4.22||3.17||2.02|
|Motor vehicle dealers and parts dealers||60,768||1.35||0.36||29.68||47.54||3.10|
|Natural gas distribution||560||0.90||0.64||2.74||7.40||1.57|
|Navigational, measuring, electromedical, and control instruments||3,938||1.06||0.61||5.38||3.38||2.26|
|New and used car dealers||43,624||1.30||0.35||27.30||62.06||2.58|
|Nondepository credit intermediation||22,801||1.03||0.83||1.09||0.00||1.52|
|Nonferrous metal production and processing||1,285||1.01||0.67||2.98||2.95||1.40|
|Nonmetallic mineral product manufacturing||5,227||2.30||1.51||8.20||11.83||3.67|
|Offices of bank holding companies||4,115||0.91||0.72||0.03||0.00||1.04|
|Offices of dentists||88,585||1.89||1.68||82.39||7.13||4.46|
|Offices of other health practitioners||140,789||1.65||1.33||20.34||9.86||4.07|
|Offices of other holding companies||72,765||1.09||0.72||0.08||0.00||1.08|
|Offices of physicians||151,830||1.16||0.95||39.09||2.58||6.61|
|Offices of real estate agents and brokers||144,434||1.38||1.05||9.98||0.00||3.49|
|Offices of health practitioners and outpatient care centers||327,078||2.11||1.78||76.42||10.85||7.44|
|Oil and gas extraction||14,507||1.09||0.90||2.92||1.65||1.33|
|Open-end investment funds (Form 1120-RIC)||18,219||3.31||0.41||0.00||0.00||1.01|
|Other administrative and support services||237,216||1.43||1.07||9.27||8.07||2.80|
|Other arts, entertainment, and recreation||88,950||1.40||0.90||21.65||4.86||3.66|
|Other building materials dealers||14,095||1.93||0.91||11.09||12.53||2.29|
|Other chemical product and preparation||1,601||1.53||0.83||4.50||4.51||2.17|
|Other consumer goods and general rental centers||8,247||1.31||0.53||22.75||1.75||3.91|
|Other electrical equipment and component||3,110||1.57||0.94||5.14||4.17||2.23|
|Other fabricated metal product||13,283||2.07||1.13||7.17||9.35||6.14|
|Other financial vehicles (including mortgage REITs)||6,621||0.60||0.44||0.02||0.00||1.01|
|Other general purpose machinery||5,551||1.50||0.89||4.46||5.84||3.66|
|Other information services||19,923||2.21||1.17||5.40||1.74||4.98|
|Other insurance related activities (third-party administrator of insurance, etc.)||16,167||1.39||1.05||4.21||1.07||3.25|
|Other miscellaneous manufacturing||18,279||2.13||1.17||4.97||7.61||2.95|
|Other motor vehicle and parts dealers||38,065||1.56||0.38||20.47||5.92||5.79|
|Other professional, scientific, and technical services||103,331||1.46||1.14||8.48||5.83||3.46|
|Other real estate activities||190,341||2.23||1.35||4.21||0.00||1.74|
|Other repair and maintenance||60,995||1.95||1.25||10.48||12.27||4.25|
|Other specialty trade contractors||315,520||1.70||1.39||9.07||12.12||7.42|
|Other transportation and support activities||54,196||0.96||0.84||5.25||1.68||5.10|
|Other information services||10,791||1.40||1.17||32.39||9.71||3.63|
|Outpatient care centers||9,128||1.33||0.89||10.25||6.06||3.14|
|Paint, coating, and adhesive||1,619||0.85||0.42||7.61||6.72||4.68|
|Paper and paper product||7,078||0.91||0.82||8.75||9.22||3.76|
|Personal and laundry services||189,729||1.50||1.00||23.28||6.90||4.77|
|Petroleum and petroleum products||5,363||1.34||0.80||14.16||13.66||1.85|
|Petroleum refineries (including integrated)||127||2.60||2.26||1.98||6.91||2.78|
|Petroleum and coal products manufacturing||659||1.51||1.00||7.52||10.58||4.41|
|Pharmaceutical and medicine||1,498||0.66||0.33||3.23||2.11||2.96|
rubber products manufacturing
|Plumbing, heating, and air-conditioning contractors||71,971||1.65||1.38||7.51||10.82||10.29|
|Primary metal manufacturing||4,317||2.32||1.28||8.14||10.84||3.43|
|Printing and related support activities||21,700||2.00||1.49||5.28||8.55||2.53|
|Professional and commercial equipment and supplies||32,471||1.15||0.76||5.89||8.26||4.20|
|Professional, scientific, and technical services||749,031||1.85||1.47||13.24||9.71||8.60|
|Property and casualty insurance||14,215||0.79||0.61||4.71||11.57||2.53|
|Publishing industries (except Internet)||21,728||1.35||1.10||7.72||7.96||5.03|
|Pulp, paper, and paperboard mills||310||1.43||0.68||9.44||8.71||1.70|
|Religious, grantmaking, civic, professional, and similar organizations||46,858||2.00||1.31||9.66||1.00||4.27|
|Rental and leasing services||28,420||4.09||2.65||6.67||6.73||2.04|
|Repair and maintenance||139,652||5.75||4.05||25.66||#DIV/0!||5.77|
|Resin, synthetic rubber, and artificial and synthetic fibers and filaments||747||1.98||1.10||6.59||7.03||4.09|
|Savings institutions, credit unions, and other depository credit intermediation||842||0.26||0.17||0.12||0.00||1.19|
|Scientific research and development services||19,114||2.32||1.61||3.78||1.83||2.87|
|Securities, commodity exchanges, and other financial investment activities||51,373||1.09||0.65||1.57||0.01||2.15|
|Semiconductor and other electronic component||3,685||1.29||0.85||5.76||3.95||4.48|
|Ship and boat building||1,177||1.04||0.44||11.52||9.55||12.97|
|Soap, cleaning compound, and toilet preparation||2,279||0.78||0.60||2.06||0.94||4.91|
|Soft drink and ice||303||1.25||0.76||9.90||4.35||6.25|
|Sound recording industries||5,543||1.10||0.67||3.58||1.80||1.26|
|Specialized design services||42,619||1.54||1.21||15.51||9.94||8.51|
|Specialty trade contractors||357,486||1.71||1.43||8.61||12.31||7.80|
|Sporting goods, hobby, book, and music stores||23,511||1.79||0.68||8.67||4.68||2.69|
|Sugar and confectionery product||1,505||0.92||0.49||10.20||4.99||9.27|
|Support activities and fishing, hunting, and trapping||28,656||1.61||0.96||13.52||10.22||5.01|
|Support activities for mining||13,594||2.17||1.67||2.68||3.03||1.49|
|Telecommunications (paging, cellular, cable, satellite, & internet service providers||16,676||1.02||0.93||1.29||0.44||2.07|
|Textile mills and textile product mills||2,471||2.16||1.05||9.38||9.51||4.48|
|Transit and ground passenger transportation||32,279||1.25||0.95||11.33||8.07||2.54|
|Transportation equipment manufacturing||5,792||2.16||1.10||9.50||11.50||4.11|
|Travel arrangement and reservation services||19,053||0.83||0.57||13.61||9.93||3.67|
|Ventilation, heating, air-conditioning, and commercial refrigeration equipment||1,108||1.80||0.99||6.09||7.52||3.60|
|Warehousing and storage||4,145||1.34||0.99||5.29||2.50||3.16|
|Waste management and remediation services||15,712||1.16||0.98||5.82||4.45||1.72|
|Water, sewage, and other systems||5,258||0.99||0.70||9.42||2.95||2.03|
|Wholesale electronic markets and agents and brokers||17,310||1.68||1.22||11.64||0.00||7.60|
|Wineries and distilleries||2,323||2.51||0.80||5.08||6.93||7.07|
|Wood product manufacturing||11,454||2.01||1.03||12.78||13.65||5.04|
Financial Ratios Explained
Below explaining each financial ratios:
Current ratio, otherwise known as the ‘working capital ratio’, is a form of liquidity ratio that indicates a company’s ability to pay back short-term obligations or the ones due within the next year. It is called ‘current’ as this ratio compares the company’s current assets with their current liabilities. Current ratio is a good tool for investors to measure a company’s ability to repay their short-term debt with their current assets.
Where according to the company’s balance sheets:
- Current assets: cash, accounts receivable, inventory, and other assets that the company plans to liquidate or convert to cash within the next one year.
- Current liabilities: accounts payable, wages, taxes payable, and immediate portion of a long term debt.
To interpret the current ratio of a company, it has to be measured against industry standards. An acceptable current ratio aligns with that of the industry average or might be slightly higher than that. This corresponds to a value of 1 or little higher than 1. A higher than industry average current ratio indicates that the company has a considerable size of short-term assets value in comparison to their short-term liabilities. Whereas the opposite indicates risk and default in the company.
It has to be noted that an extremely high current ratio also spells trouble. A score higher than 3 indicates that the company management is failing to use their current assets efficiently, not adopting the right strategies of financing, or failing to manage their working capital.
Quick ratio, also called the ‘acid-test ratio’, indicates the dollar amount of liquid assets available against the dollar amount of the company’s current liabilities. This measures the company’s ability to meet its short-terms obligations using its liquid assets (that can be quickly converted to cash). Quick ratio is also a quick test to predict the company’s capacity to pay its current liabilities without having to sell its inventory for a loss or raise additional funds.
All of these terms can be found under the current assets and current liabilities section in the balance sheet. While calculating please note that liquid assets are those that can be easily converted to cash within 90 days. Similarly, only those should be considered under account receivables which can be collected from the company’s customers within 90 days.
A value of 1 indicates a normal quick ratio. This means that the company has enough assets to liquidate and pay off their current liabilities instantly. Scores higher than 1 indicates good health of the company’s debt scenario. For example, a quick ratio of 1.7 indicates that the company has $1.70 liquid assets available for every $1 of their current liabilities. Companies with quick ratio less than 1 may not be in a position to pay-off their current liabilities in the immediate future indicating high risk debt.
In comparison, the quick ratio is far more conservative than the current ratio which accounts for only the current assets. Nevertheless, a fair judgment of the company’s liquidity position can only be assessed when multiple ratios are considered in unison.
Net sales / Net Trade Receivables
The accounts receivables ratio indicates the total number of times a company manages to collect its average accounts receivable balance from its customers in a year. This ratio, also known as the debtor’s turnover ratio, is an efficiency ratio that indicates the company’s ability in collecting revenue from its customers.
The accounts receivables turnover ratio helps determine such lapses and directs the company towards a healthy accounting system with respect to its customers. This ratio is also frequently used in financial modeling as an important assumption for balance sheet forecast.
Further, to get the account receivables turnover in days, divide 365 by the accounts receivable turnover ratio. This will give the average number of days your customer takes to pay their debts.
The ratio is high in three cases:
- Company has an efficient system of collection of accounts receivable
- Company has a quality customer base who clear debts quickly
- Company follows a conservative credit policy (10 – 20 days net)
The ratio is low in three cases:
- Company’s collection system is inefficient
- Company is extending credit to non-creditworthy customers
- Company’s credit policy is too long
Either way, average accounts receivable ratio of a company will not make sense as a standalone number. This score has to be compared with competitors and industry benchmarks to make good sense of it.
Inventories are those goods in stock of a company that it plans to sell. The rate at which a company replaces inventory through sales in a given period of time is indicated by the inventory turnover ratio. In other words, this ratio is a measure of how well a company is generating sales from its inventory. This ratio is an important determiner of pricing, manufacturing, marketing, and purchasing decisions. If inventory levels are well managed by the company, it indicates that sales are as estimated and costs are controlled.
Further, to get the specific number of days it takes for the company to convert inventory to sales, the measure of day’s sales of inventory is used. A lower DSI is optimal as it indicates lesser days required to convert inventory to sales.
The inventory turnover ratio provides a snapshot about the company’s stock management and whether the sales and purchasing department are working in sync. The best scenario is when the inventory matches sales. A higher inventory turnover ratio is ideal as it indicates that sales are quick and there is a demand for the company’s products as well. A lower ratio indicates the contrary. However, at times, a higher inventory ratio could also cause loss of sales as there is no inventory left to sell. Thus the ratio must be compared to the industry benchmark to get the true picture of this score.
Accounts payable turnover ratio is used to measure a company’s capacity of short-term liquidity. Also known as the ‘payables turnover ratio’ or ‘creditor’s turnover ratio’, this liquidity ratio measures the number of times a company pays its creditors over an accounting period. Creditors use this ratio as an indicator to measure a company’s creditworthiness. However the ratio will eventually depend on the terms set by the suppliers based on their relationship with the company and their bargaining power.
Net credit purchases may be substituted at times by COGS and
Average accounts payable = sum of accounts payable at the beginning and end of accounting period / 2
To get the average number of days that the payable amount remains unpaid, simply divide 365 by the payable turnover ratio.
A high payable turnover ratio indicates:
- Suppliers are receiving prompt payments for their sales on credit
- Suppliers are demanding quick payment terms
- Company is striving to utilize early payment discounts
A low payable turnover ratio indicates:
- Suppliers receiving slow payments for their sales on credit
- Company facing issues with cash, at risk of financial problems
- Company has managed to strike favorable credit terms with the supplier
Though a higher payable turnover ratio indicates the creditworthiness of a company, the company must strive towards favorable credit terms with their suppliers so that they do not have to make hurried and frequent payments, in which they run the risk of penalties. It is in favor of the company to be in a comfortable cash flow scenario. However as is the case with all financial ratios, a company should compare their ratio with their competitors and industry standards to make sense of best practices suited for their business.
Net Sales / Working Capital
The working capital turnover indicates how well a company is using its working capital to support sales. This turnover ratio helps determine the relationship between the funds used by the company and the revenue generated with it.
Where working capital of a company is (current assets – current liabilities).
Net annual sales = total sale by the company during the accounting period
Average working capital = (Working capital at the start of accounting period – at the end of the accounting period) / 2
A high working capital turnover ratio indicates –
- Money is flowing in and out allowing the company flexibility in expansion and inventory
- Company’s finances are stable, less dependence on additional funding
- Company has a competitive edge over other businesses in the market
- Management is efficiently using short-term assets and liabilities to support sales
A lower working capital turnover ratio indicates –
- Company investing heavily in accounts receivables and inventory to support sales
- Company has a lot of bad debt
To make sense of the working capital turnover ratio, it is advisable to track it over a period of time before drawing conclusions. Needless to say, the company has to compare its ratio with others in the industry to gauge its operating efficiency.
The interest coverage ratio is an indicator of the company’s ability to pay interest on its outstanding debt. Also known as the ‘times-interest-earned’ ratio, this is used by lenders, creditors, and investors to gauge the risk factor involved in lending capital to the company. In other words, the interest coverage ratio is a measure of the safety margin a company has to pay interest on its outstanding debt during the accounting period.
A higher ratio automatically indicates the company’s strong financial position, attracting more investors. While a lower ratio points towards the company’s overburdened debt expenditures. A score of 1.5 or lower is a clear red flag indicating the company’s unstable financial position. A company with such a low interest coverage ratio might not be in a position to pay their debt very soon. However, this ratio has to be analyzed over a period of time to understand trends and in comparison with industry benchmarks.
% EBT / Total Assets
The return on total assets (ROTA) ratio measures how efficiently a company is generating income using its assets. It helps identify the companies in a business with the best practices of using their assets in comparison to their earnings. This ratio provides an insight between the company’s resources and income.
A higher ratio is favorable for the company as it indicates its efficiency in handling assets whereas a lower ratio indicates the opposite.
Net Sales/Net Fixed Assets
The fixed asset turnover ratio (FAT) is an indicator of the company’s efficiency of using its fixed assets to generate net sales. It is used to measure a company’s operating performance and when annually calculated, reveals the management’s ability to use significant assets of the company to generate revenue.
This ratio will vary with industry based on the measure of their fixed assets. For example, this ratio is likely to be used as a reliable measure of net sales vs fixed assets in a manufacturing company which invests heavily in fixed assets such as the property, plant, and equipment (PPE).
A higher FAT ratio indicates that the management has efficiently used its fixed assets to generate revenue for the company while a lower FAT ratio points at the opposite. However, there is no reference score or range for FAT ratio. The best way to use this ratio is to compare the company’s present ratio to its historical ratio as well as the one of competitors and industry average.
Net Sales/Total Assets
Asset turnover ratio is the measure of a company’s efficiency in using its assets to generate revenue. It is a ratio of the total sales to the average assets. Investors use this ratio to monitor a company’s usage of assets for revenue generation. This ratio also helps to compare various companies in the same sector.
Higher the asset turnover ratio, better the company’s performance as it indicates that the company is generating substantial revenue based on its assets. Similar to FAT, asset turnover ratio will also vary with industry. This ratio will be applicable mostly to those companies that have a significant investment in assets. But unlike FAT that accounts for only fixed assets, asset turnover ratio accounts for an average of total assets. This ratio too does not have a range and needs to be compared with the company’s previous ratios and those of similar businesses in the industry.
% Non-Cash Expenses / Net Sales
%Non-Cash Expenses / Net Sales is a measure of the company’s non-cash expenses to sales. It is used to measure how much additional expenses (Depreciation, Amortization, Interest, Taxes, etc.) incurred by the company and what percentage of this is to the total sales.
A higher ratio may indicate that the company is more leveraged with debt than its competitors, or incurs more depreciation due to fixed assets, if in an asset heavy industry. A lower ratio may show that the company is less burdened with debt or incurs more cash expenses in its daily operations.
% Off. Compensation/Net Sales
% Off. Compensation/Net Sales is a measure of the company’s officers compensation to sales. This is an important industry benchmark to show how much the company compensates the officers when compared to its competitors.
A higher ratio would show that the officers are compensated well, and vice versa. The company should find a good balance between enough compensation for the hard work of the officers and having enough working capital for the company to grow at a steady rate.
As we see, the applicability of multiple financial ratios directly impacts a business valuation. Entrepreneurs have to bear the responsibility of getting it right to the best of their abilities. A faulty business valuation can deprive the company of its much needed investments and distort their growth metrics. Our expert team of analysts at Eqvista can support you through this process. We specialize in managing cap tables, company shares, and valuations in an easy and effective manner. Learn more about our online cap table and our 409a valuation services. For specific queries reach us today.