Financial Statements Basics: Part 3, with Jason Pereira | E085

Accounting Ratios & Analysis.

Today is the third part of the continuation of a series that Jason is doing on understanding financial statements. Today, Jason is going to talk about accounting ratios. Accounting ratios are used to analyze your business in several different ways. First, it’s helpful to track the performance of your business in multiple different facets, from its solvency to its profitability to its efficiency. It also is a valuable tool if you can combine comparing the help of your business with another business.

Episode Highlights:

  • 1.26: Accounting ratio is taking one number from your financial statements and doing something in relation to other numbers. Depending on the context that you are measuring, it gives you a piece of information that can help you better understand your business’s operations.

  • 1.58: Liquidity ratios measure how effectively the company can repay both short- and long-term obligations. The most important ones tend to focus on current long-term liabilities.

  • 3.22: When you sell a product from inventory, you sell out a profit that is not reflected on the balance sheet.

  • 3.37: The asset test ratio subtracts out inventories from current assets. If your inventory turnover is very frequently like short-term stuff, and it never sits around for very long, that converts the cash quickly.

  • 4.23: The cash ratio carves all current assets except for cash and cash equivalents compared and devised by current liabilities.

  • 5.45: The leverage ratios measure the amount of capital that comes in the form of debt. It’s basically how much leverage you are employing in the business relative to some other important metrics.

  • 8.28: The debt service coverage ratio looks at your operating income, but it looks like your total debt service, not just the interest but also the principal payments.

  • 9.30: The asset turnover ratio looks like your net sales divided by your average total assets. The average total assets are arrived at by taking the start period of last year’s assets, adding the current year’s assets, and dividing that by two.

  • 10.35: The inventory turnover ratio is the cost of goods sold divided by your average inventory. It measures what you paid for your inventory and essentially how much of it you keep on the books and how often you are flipping that.

  • 11.45: Accounts receivable turnover measures how effective you are at collecting your receivables. The bigger the credit sales number and the smaller the average means that you have a very effective means of collecting money as fast as possible.

  • 12.50: Days sales inventory ratio tells us how many days on average you hold inventory before it gets sold. This number should be as small as possible because it will help you reduce your working capital investment. 

  • 14.36: There are the EBIT earnings before interest in taxation. Even though depreciation is on a cash expense, you were using up the life of your materials, goods, and equipment, which is important because that represents an eventual cash flow.

  • 15.00: The EBT margin tells us how much our profit margins were before taxation, which is the metric for how your business will deal.

  • 15.48: The net income divided by shareholder’s equity is the return on equity ratio. It is valuable because this tells you what your actual ROI is on the investment made in the business and not given.

  • 16.55: The market value ratios give you a metric for how your business is doing in terms of the investment value from your standpoint as an investor.

  • 17.46: The book value per share ratio takes the shareholder’s equity minus preferred equity. This may not apply to private businesses, but in public, it does.

  • 18.31: Dividend yield ratio tells you is the dividends per share divided by the share price, and share prices have arrived at by the value of shares of the company divided by the number of shares outstanding.

  • 19.24: The earnings per share ratio is truly a metric of how much of the business’s profitability belongs to each shareholder. You take the net earnings or net income and divide that by total shares.

  • 20.17: Other ratios get into, and you can make up your own as long as it measures something relatively important to your business. 

3 Key Points:

  1. Instead of looking at current liabilities from the lens of your current assets, the operating cash flow ratio looks at operations. It takes your operating cash flow and the cash generated from operations. 

  2. The interest coverage ratio measures your interest obligations on all your debt, like your operating income divided by your interest expenses. The interest coverage ratio is an important one in the short run.

  3. The gross margin is your gross profit divided by your net sales. Gross profit margin is looking at the direct cost of unit sale like the cost of goods sold, cost of services rendered, whatever that related specifically to that sale.

Tweetable Quotes:

  • “The current ratio looks at current assets and divides them by current liabilities. It tells you that you have enough cash and convertible assets in cash.” - Jason

  • “The debt-equity ratio is taken from your total liabilities and divided by your shareholder’s equity. This is a metric of how you finance your business essentially.” - Jason

  • “In many cases, businesses can rely upon lines of credit that do not require anything much more than interest payments at least every month.” - Jason

  • “You take your net income and divide it by the total assets that tell you what annual return you earn on your assets deployed, and that is the return on assets ratio.” - Jason

Resources Mentioned:

Full Transcript;

Producer: Welcome to the Financial Planning for Canadian Business Owners Podcast. You will  hear about industry insights with award-winning financial planner and entrepreneur,  Jason Pereira. Through the interviews with different experts, with their stories and  advice, you will learn how you can navigate the challenges of being an entrepreneur,  plan for success and make the most of your business in life. And now your host, Jason  Pereira. 

Jason Pereira: Hello, welcome. Welcome to the third episode of my series on financial statements  and analysis. Previously, we had covered the income statement, balance sheet and  cash flow statements, and a little bit about cash flow management. And we might do  a little bit more today just depending on how long I run. So basically today, what  we're going to do is something a little bit different. We're going to look at accounting  ratios. Accounting ratios are used to analyze your business in a number of different  ways. It's helpful to track the performance of your business in multiple different  facets from its solvency to its profitability, to its efficiency. And there's a number of  ratios that can basically help do this. In fact, it also is a valuable tool for if you can  find a comparable, comparing the health of your business to another business, and in  your industry in particular, because industries typically tend to be similar in  operations. You don't want to compare apples to oranges. 

Jason Pereira: So what is an accounting ratio? Simply put, an accounting ratio is taking one number  from some on your financial statements and doing something with it in relation to  other numbers. And what this does is it gives you a piece of information that can,  depending on context and what you're measuring, can help you understand the  operations of your business better and most importantly, the health. So before we  get started, I just want to say, if you can pull out your income statement, balance  sheet and cash flow statement from your accounting software, it's probably a good  idea to have those with you as we go along, so you can understand what I'm talking  about in a little more detail. 

Jason Pereira: So first off, let's talk about the first category of ratios, liquidity ratios. Liquidity  ratios are basically a measure of how effectively or the company's ability to repay  both short and long term obligations. The most common liquidity ratios and the most  important ones tend to focus on current liabilities versus long term, because current  liabilities have to be paid within the current 12 month period. So basically when we  look at this, the kind of starting point for all this is what's known as the current  ratio. The current ratio looks at current assets and divides it by current liabilities.  And what that tells you is do you have enough cash and assets that are basically  convertible to cash in the next 12 months available to you to pay off all the bills you  have in the current 12 months as well? 

Jason Pereira: That includes on one side, current assets we discussed before, cash, cash  equivalents, receivables, and inventories, and some other stuff like work in progress.  And then on the other side you have, current liabilities. So that includes all your  vendors that you have to pay, current portion of long term debt for the lets do in this  year, and things like taxes for the year that you are owning. So there's a number of  short term liabilities there we went over last time. The ideal for this is a minimum  score of one. One divided by the other should be equal to at least one, if not, then  basically you do not have enough cash and current assets to pay off your current  liabilities. That might be a problem, might not be depends, right? Because when you  basically sell a product in inventory, you sell it at a profit, hopefully. And that  actually, that profit's not reflected on the balance sheet. So it might be an issue,  might not be, depends on the nature of your business. But in general, you want that  number to be greater than once so that you can meet your obligations. 

Jason Pereira: The second one is the asset test ratio. The asset test ratio, subtracts out inventories  from current assets. Now, why would you do this? Depends on the nature of your  business. Again, if your inventories turn over very frequently, like we're talking daily  or weekly, you know, very short term stuff and it never sits around for very long  then, hey, that's okay because that converts the cash pretty quickly. So the current  ratio's probably okay. But if you're holding onto inventory, say heavy equipment for  months on end and that's normal, then that's something that doesn't convert to cash  quite quickly enough and may not be available to you to pay current liabilities. In  which case the asset test ratio is a probably a better metric with, again, the same  benchmark of at least one. 

Jason Pereira: The third ratio in this series is basically the most stringent of them all, it's the cash  ratio. And this carves out all current assets with the exception of cash and cash  equivalents, compare and divides that by current liabilities. And this really measures  your business' current ability at this moment to basically pay off its current liabilities  for the year. This is the most stringent of all of these. Now, if you're in a cash and  carry business with high turnover of inventory, then this is probably healthy and  probably fine. But if you've got decent payment terms and your business is steady,  then frankly, there's no reason that you should be breaking your neck to try to get  this ratio above one. Although, hey, you do need sufficient working capital, and we're  going to talk about that later. 

Jason Pereira: Another ratio in this category is the operating cash flow ratio. So what this does, is  instead of looking at current liabilities from the lens of your current assets, it looks  at it from operations. So basically it takes your operating cash flow, which we went  over last time, which is basically the cash you generate from operations, this can be found on your cash flow statement, and compares that to current liabilities. Ideally  this should of course be north of one. Why? Because otherwise you are not  generating enough cash from operations to meet your current liabilities. In which case come next year, or coming at the end of the period, your asset totals are going  to be lower than they were at the start of the year. Can you do that for a short  period of time? Sure. Can you do that indefinitely? No, probably not. That's a  financial hardship issue. So those are the main liquidity ratios. 

Jason Pereira: Now let's move on to what are known as the leverage ratios. The leverage ratios are  a measure of the amount of capital that comes in the form of debt. In other words,  it's basically how much leverage are you employing in the business relative to some  other important metrics? So the first one is the simplest, the debt ratio. What are  your total liabilities divided by your total assets? And why is this important? Well, it  just measures solvency. Can you pay off everything? Can the business pay off  everything it owes based on the assets it has on the books? If not, technically you're  insolvent on paper and frankly something needs to be done. You can maintain that  for a while, but if those liabilities come due, if that asset to total doesn't increase to  meet that challenge, you have a problem. 

Jason Pereira: The next one is the debt equity ratio. Basically this is as described. You take your  total liabilities and divide it by your shareholders equity. This is a metric of how you  financed your business, essentially. So are you a more debt liquidating business, or  was there significant amounts of owners, equity invested and maintained within the  business? And essentially this is also another form of solvency ratio. If your business  is struggling and you're seeing a total liabilities versus shareholders equity imbalance  where it's a high number, you're probably too debt lagged. You're going to need  shareholders equity. And if your debt to equity ratio is likely is very small or barely  existent or the first number is zero, you're probably not employing debt within the  business that you could employ to help you grow or be more profitable. So debt is a  good and bad thing in life. And we've done over this on this podcast before. It's good  if it enables you to earn a good return specifically around your business, around your  education, any number of things. So when used in wisdom, it is valuable, when used  foolishly, it can crush you, but this is one of those metrics that can inform a decision. 

Jason Pereira: The next one, and this is more of a important one in the short run is the interest  coverage ratio. So this basically measures, just looking at your interest obligations on  all your debt. What is your operating income divided by your interest expenses? Why  is this important? It tells you how much income you generate relative to the amount  of debt carrying costs. And that is important because if that number is not above  one, you're in trouble. Why? Because if you are not generating enough income to at  least cover your interest expenses, you're at massive risk or you're going to default  and as soon as you run out of assets to liquidate. So frankly, this is a kind of help the  business. You want this number to be big. Now you don't want this number to be  undefined, meaning that interest is zero. Again, if you're not employing debt within  the business that might be holding you back from opportunities around expansion or recapitalization, meaning pulling some other money out personally and reducing your  shareholders equity exposure. 

Jason Pereira: Next one is debt service coverage ratio. So the debt service coverage ratio looks at  your operating income like before, but it looks at your total debt service. So not just  the interest, but also the principle payments. Why carve out these two? Because in  many cases, businesses can rely upon lines of credit, which do not require anything  much more than interest payments at the very least every month. So that's why the  interest coverage ratio is important, but debt service is more important because that  also means your principle repayment. Now you may or may not be able to re-access  that or re-advance that money, which is why both metrics are relevant. So I'd say the  one that's more important here depends on the nature of your debt. If you have a  term loan and you are probably not going to be able to get that term loan again, total  debt service ratio is probably the most valuable. If you have a re-advanceable form of  debt that you can access, then the interest coverage ratio is probably the most  important one there. 

Jason Pereira: So then we move on to efficiency ratios. Now these basically, what they do, is that  they look at how the company's utilizing its assets and resources to create revenue  and how effective that is. So the first one is the asset turnover ratio. And the asset turnover ratio looks at your net sales divided by your average total assets. So the  average total assets are arrived at by taking the start of period or one year's, last  year's assets, and adding the current year's assets and dividing that by two,  straightforward. And what it's just trying to look at is what was the average amount  of capital you had deployed or assets you had deployed? And what were the sales  relevant to that? So how many dollars of sales did you generate per total dollar  invested? 

Jason Pereira: Now, obviously this is a lot better if it's higher and this is very much dependent upon  the nature of one's business. But really, you want to have a very big number here if  you can. Now that's again, it's just based on the nature of the business, but it just  tells you again, roughly, especially when you're looking at investing your business, if  you basically make $2 for every $3 you invest in the business is assets, or for the  assets that you grow, then you can start to determine trade offs within the business  and form your decisions regarding expansion. 

Jason Pereira: Inventory turnover, this one's a particular interest that we're going to come back to  later. So the inventory turnover ratio, this is your cost of goods sold, divided by your  average inventory. Why does this matter? Well, basically it's measuring what you  paid for your inventory and essentially how much of it you keep on the books and  how many times over you're flipping that. So this is a measure, in a way, a measure  of how effective you are at inventory management, because inventory costs money to keep around. So if you basically have too much inventory, that is an investment in  your business that maybe doesn't need to happen. 

Jason Pereira: Ideally, in a perfect world, the inventory comes in and is sold the next minute. Now  that's borderline impossible. And frankly, if you tried to do that, you probably would  lose sales because there would be delays in arrival and you would miss that sale  opportunity. But essentially what you want this to be, depending on the business,  well, in most cases you want this number to be as high as possible because that  means a high cost of goods sold, so a lot of cost related to sales of that product and  an inventory number as small as possible, that just means that you're constantly  cycling through the inventory with little need for investment in that aspect of  working capital and little need for warehousing, if necessary. This again, of course,  big asterisk behind all this, depends on the industry you're in as to what a relevant  number is here. 

Jason Pereira: So next onto accounts receivable turnover. So this is a measure of how effective you  are at collecting your receivables. So what you do is essentially you take your net  credit sales or whatever sales are done with collection terms that aren't basically  collecting immediately, and divide that by the average accounts receivable. So the  bigger the credit sales number and the smaller the average, means that you basically  have a very effective means of collecting money as fast as possible. This is good. And  you want to see this big, but you don't want to necessarily see it too big. It just  depends on the nature of your business. For example, if you're in a business that  basically has standard terms of a 30-day collection or a 60-day collection, you want  to make sure that your clients are offered sufficient payment terms in terms of how  long they have to pay, that you're not leaving sales on the table, as long as you're  able to make the working capital investment to make that happen. So receivables  turnover, again, depends on where you are basically, what kind of industry you're  participating in. 

Jason Pereira: The next one is days of sales in inventory ratio. So basically how you measure this is  365, number of days, divided by your inventory turnover ratio. The previous number  we basically got earlier. So what is this telling us? This tells us how many days on  average you hold inventory before it gets sold. Clearly this number should be as small  as possible because it will basically help you reduce your working capital investment.  Again, not so small that it costs you sales, but small enough that basically you're not  having a tremendous amount of volume that you have to worry about pushing out  later. 

Jason Pereira: Now, we'll move on to the profitability ratios. Now we can measure profitability in a  couple different ways. Of course, net income is one we're going to get to, but you  want to really measure the effectiveness of your business to create profit at multiple spots along the income statement. So we're going to start off with the gross margin. The gross margin is your gross profit divided by your net sales. So gross profit margin  is basically looking at what was the direct cost of that unit of sale? Cost of goods  sold, cost of services rendered, whatever it is that were related specifically to that  sale. You're taking that and dividing that by net sales. That gives you a percentage of  how much you "profited" over the raw materials or inputs that basically were  required in order to make that unit of sale. And that is valuable in a lot of reasons,  because ideally you want to distribute a product or solution for the highest possible  gross margin. Now that's the starting point. 

Jason Pereira: The second one is the operating margin ratio. So that takes your operating income  divided by your net sales. So again, this is looking at things like EBITDA. So why is  this important, because EBITDA will include your costs that were fixed. So what this  tells you is that the total, actual operational margin that you have, which of course  should be positive and hopefully big. 

Jason Pereira: The next ratios to consider. Now we can keep on going to the balance sheet. We have  kind of the EBITDA gross margin ratio, look at the other expenses that we need to  include. So there's the EBIT earnings interest in taxation, because even though  depreciation is not a cash expense, you are using up the life of your materials and  goods and equipment. And that is important because that represents an eventual  cashflow down the road, so we're just making sure we properly account for it per  unit. So the EBIT margin is just another step down. Then we can look at the earnings  before taxes, the EBT margin, which basically tells us how much our profit margins  were before taxation, which is really the metric for how your business really did.  Now, I know you really don't get to E there before tax, but tax is a variable  determined, and that's how your control in all honesty. So you want to focus on that  number. 

Jason Pereira: And of course you have the net income margin, which is looking at everything,  including your taxes gone and how much you actually profited in accounting, cause  again, not cash flow, but how much you actually profited all the books as a  percentage of total sales. So again, you can look at different levels or different  metrics along the way down the income statement. 

Jason Pereira: Then we have the return on assets ratio. You take your net income and you divide it  by your total assets, that tells you what annual rate return you're earning on your  assets deployed. Why is that valuable? Because again, you want that number to be  positive and as big as possible. 

Jason Pereira: Then you have the return on equity ratio. Return on equity ratio is the net income  divided by shareholders equity, valuable because this tells you what your actual ROI  is on the investment made in the business in that given year. Now shareholders  equity will move up and down. It will move up with investments and with retained  earnings. It will move down with dividends. Now this is reflective of your net  investment. Why? Because earnings left behind the business that you don't take out  as dividends, that is a reinvestment in the business. And sometimes people have their  hard time wrapping their heads around that, but that's what it represents. And  dividends represent a withdrawal from your investments. So net income developed by  shareholders equity of course, you want this number to be big because that means  that you, for what money you've put into it, that return is high. Now, again, this  again depends on the nature of the business, but hopefully it should be high enough  that you are earning a return on your money that is better, I would say than most  public market companies. Why? Because if I can buy a stock index and earn a  respectable historical way to return, well, I'm taking on a lot more risk in being a  business owner. So frankly, the ROI I get from this should be substantially a little  higher. 

Jason Pereira: Speaking evaluations, now it's time to move on to the market value ratios. So market  value ratios basically give you a metric as to how your business is doing in terms of  the investment value, from your standpoint as an investor. Now in a public company,  this is easy. In a private company, this is more difficult. Now that said, in my  previous episodes of my podcast and also my FinTech Impact Podcast, I profiled two  companies, one in the US, one in Canada that can produce valuation reports on an  ongoing basis for your business, telling you roughly what your business is worth. So  that is, if you can get that or if you know what the general ratios use in your  business. So if you know what kind of ratios are used in your industry or multiples  are used in your industry to value your business, you can use those as a guidepost to  give you a right idea. 

Jason Pereira: Now, you'll never really know until the business is on sale, but this will at least if you  use these consistently, we'll give you a metric to understand roughly what you're  returning. The first one is the book value per share ratio. So this takes the  shareholders equity minus preferred equity. That may not actually apply with private  businesses, but in public it does. And then divides that by the total common shares  outstanding. So what is this telling you? This is telling you per individual share you  own, what is the book value of basically your equity? So what was the shareholder's  equity put in per share roughly? And that also represents of course, changes. So  dividends cause a negative and retained earnings increase it. 

Jason Pereira: The next one is dividend yield. And this is particularly of interest, specifically if you  are an individual who is say a passive investor in a private company, right? You have  maybe bought shares in a friends company or some startup. Well, most startups don't pay dividends, but more shared ones do. So what does the dividend yield ratio tell  you, it's the dividends per share divided by the share price. And share price is arrived  at by value of shares of the company divided by number of shares outstanding. So the  dividend per dividend yield tells you what basically you are receiving as dividends as  a percentage of the value of the company. Very consistent in publicly cut, traded  companies, pretty wild and all over the place in private companies. And keep in mind  when it comes to dividend policy as to when it makes sense, I will take Warren Buffet  up on his interpretation of this, it's basically paid out when there's a consistent  amount of cash flow, more than it is needed to operate the business and invest in  ideas or expansion of the business, that makes logical sense at the rates of return  that investors are expecting. So you're spitting off more money than you know what  to do with, that's when dividends makes sense. 

Jason Pereira: Okay, moving on. Then we get to the earnings per share ratio. And this is truly a  metric of how much of the profitability of the business belongs to each shareholder.  You take the net earnings or net income and divide that by total shares outstanding,  pretty straight forward. So that is what's known as the EPS ratio and is used both  publicly and privately. 

Jason Pereira: And then we have the price earnings ratio. Price earnings ratio sort of flips on  instead. It's the share price or the value per share of your private companies and  divide that by the EPS, the earnings per share. And that tells you essentially what the  price per dollar of earnings is. So this ratio is really one for comparing to other  investment options. If you have like in public markets, typically high price earnings  companies are expensive to buy earnings and low are basically cheaper. And there's  all kinds of financial metrics behind when one of those makes sense. 

Jason Pereira: So here's the thing, we've gone over these and there's a lot and a lot to basically  follow along with and for yourself. But as I just went through, there are liquidity,  leverage, efficiency, profitability, and market value ratios. There are also other ratios  that I didn't get into. And frankly you can make up your own as long as it measures  something relatively important to your business. So basically my advice to you is,  don't try to focus on every last one of these. Figure out based on your industry and  your operations and when you feel business stress, which one or ones of these ratios  in your business are relevant to you, and basically track those and track the evolution  over time. And try to get some sort of benchmark data if you can find it on other  companies in your industry. 

Jason Pereira: Now, this is not the end of accounting ratios. You can have non-financial accounting  ratios. I have several of these in my business to help track the health of the business.  So what do those include? Things like revenue per household serve, number of  households per advisor, number of full-time equivalent staff per dollar revenue. So there are different benchmarks that you can create yourself. Don't go wild, focus in  on a handful that are core to your business, and what I mean by core to your  business, if you can make those optimal or as large as possible, or as small as  possible, depending on which way it's measuring, that will have the biggest impact on  the net profitability of your business. Because at the end of the day, the net profit  number is the one you're trying to increase, not necessarily the ratio. Sometimes if  your profitability as a percentage is too high, it may be a sign that you're not  reinvesting in your business enough. So this is something that is unique to every  business. 

Jason Pereira: I suggest that, you know, have a conversation with your advisors, specifically your  accountants and any other people you want. There's also lots of business coaches out  there who can help you with this and make a habit of tracking it. Now, some  accounting systems can do this, not all. There are some standalone companies for  tracking this. So one I use is a company called FathomHQ. It will suck up your  accounting data. It will let you select your KPIs and it will calculate it on a monthly  basis and produce a report monthly, quarterly, annually, to give you an idea of how  you're doing and also track that against your long-term productivity or your long term changes. 

Jason Pereira: So that is the episode on accounting ratios. That is, we're pushing up over 25 minutes  now so I want to be cautious of time. I am going to next episode, wrap up this series  in particular with the discussion around free cashflow and cash conversion cycles,  and how to basically manage your working capital. As always, if you enjoyed this  podcast, please a review on Apple podcast, SoundCloud, Stitcher, Spotify, or  whatever is it you podcast. Until next time, take care. 

Producer: This podcast was brought to you by Woodgate Financial, an award-winning financial  planning firm, catering to high net worth individuals, business owners, and their  families. To learn more, go to woodgate.com. You could subscribe to this podcast on  Apple podcast, Stitcher, Google play, and Spotify, or find more episodes  @jasonpereira.ca. You can even ask Siri, Alexa or Google Home to subscribe for you.