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:
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.
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.
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.