Do Your Financial Statements Contain Hidden Messages?November 27, 2017
Over time, many business owners develop a sixth sense: They learn how to “read” a financial statement by computing financial ratios and comparing them to the company’s results over time and against those of competitors. Here are some key performance indicators (KPIs) that can help you benchmark your company’s performance in three critical areas.
“Liquid” companies have sufficient current assets to meet their current obligations. Cash is obviously the most liquid asset, followed by marketable securities, receivables and inventory.
Working capital — the difference between current assets and current liabilities — is one way to measure liquidity. Other KPIs that assess liquidity include working capital as a percentage of total assets and the current ratio (current assets divided by current liabilities). A more rigorous benchmark is the acid (or quick) test, which excludes inventory and prepaid assets from the equation.
When it comes to measuring profitability, public companies tend to focus on earnings per share. But private firms typically look at profit margin (net income divided by revenue) and gross margin (gross profits divided by revenue).
For meaningful comparisons, you’ll need to adjust for nonrecurring items, discretionary spending and related-party transactions. When comparing your business to other companies with different tax strategies, capital structures or depreciation methods, it may be useful to compare earnings before interest, taxes, depreciation and amortization (EBITDA).
3. Asset management
Turnover ratios show how efficiently companies manage their assets. Total asset turnover (sales divided by total assets) estimates how many dollars in revenue a company generates for every dollar invested in assets. In general, the more dollars earned, the more efficiently assets are used.
Turnover ratios also can be measured for each specific category of assets. For example, you can calculate receivables turnover ratios in terms of days. The collection period equals average receivables divided by annual sales multiplied by 365 days. A collection period of 45 days indicates that the company takes an average of one and one-half months to collect invoices.
It’s all relative
The amounts reported on a company’s financial statements are meaningless without a relevant basis of comparison. Contact us for help identifying KPIs and benchmarking your company’s performance over time or against competitors in your industry.