What are the best financial ratios to use when assessing the functional areas of a business?
I am currently building an automated tool that prospective clients will be able to download free from my (revamped - in progress) website to provide an overall assessment of the performance of functional areas in their business. The tool will generate reports based on financial ratios. The following ratios will be used, and I would appreciate recommendations on any others you would recommend to get a good overall view of all functional areas:
Working Capital Ratio
Working Capital % of Sales
Gross Profit Margin
Net Profit Margin
Operating Expense Ratio
Return On Assets
Return On Equity
Accounts Receivable Turnover
Days In Accounts Receivable
Accounts Payable Turnover
Days In Accounts Payable
Days In Inventory
Total Asset Turnover
While I personally have long been a fan of ratios in business analysis; I urge caution in the interpretation of them. The following website identifies a robust set of ratios but also points out most ratios by themselves are meaningless. See their section identifying the use and limitations of financial ratios. http://www.netmba.com/finance/financial/ratios/
What a great idea! Instead of recommending the best ratios to use I would like to recommend that you provide clients a more customized tool. Some of these financial measures will be more meaningful for specific industries. For example, a company that does not carry inventory will find little use for the inventory ratios. I suggest you build in a query that hones in on your clients industry. You could even collect your clients data, with a disclosure you are doing so of course, and present industry averages. Other websites like yahoo finance offer similar tools but they focus on public companies. Your tool could provide useful performance measures for smaller private companies.
Let me know if you'd like to discuss this further. This sounds like an interesting tool, great idea!
You may wish to include following ratios for companies having Debt on their Balance sheet:
Debt Service Coverage Ratio
Interest Coverage Ratio
Current or Quick Ratio
I value companies for a living and I can tell you all these numbers change from industry to industry there is no norm across the board. If you want to put the time in, you could categorize each industry then plug in the numbers for industry trends.
May I suggest to include:
Sales and profit per headaccount.
Let me know what was the end up of this project. It can be interesting to us.
I'm going to have to be honest, but force ranking these ratios would not provide as much benefit as creating a matrix that takes into account the strengths and weakness of a business.
The pros and cons of all of these metrics are covered ad nauseum in business valuation and corporate finance textbooks.
...company and departmental financial ratios, goal-achievement, and market value.
Depends on each prospective client's needs, business stage, etc., but in my space of private equity, family office, sovereign fund, etc. capital markets, I would say the number one financial performance would be EBITDA on revenue ratio. Dave Cochran, Cochran Edwards Capital Partners, Seattle
All of these values are good, and as others have mentioned, should be used more as a guideline in judging your business. I would have the tool pay attention to Free Cash Flow. Understanding this is critical for business valuation, and having a way to allow businesses to model their flows and see how it can impact business decisions/investments would be useful as well. Good luck!
This is an extensive list of ratios, and I guess much will depend on your target audience. For Small Medium Enterprises (SME), I'd suggest trimming the list to 1. Profitability Ratios;
G.P.M., N.P.M., Operating Profit Margin (profits before taxes and interest/Sales), R.O.A.,
2. Liquidity Ratios;
Current Ratio, Acid test, Inventory to N.W.C.
3. Leverage Ratios;
Debt-to-assets ratio; debt-to-equity ratio
4. Activity Ratios;
Inventory turnover, Fixed assets turnover,Total assets turnover, Accounts receivable, Average collection period.
For listed companies, I'd add P/E ratio, Dividend yield on common stock, Dividend payout, Cash flow per share.
Your initiative sounds very interesting and I'd welcome a sight of the finished article - hope this helps, if only to confirm that you're on the right track.
Hello again folks,
I just thought I'd pop back here to let you all know that the project I was working on is now complete, and full details of the 'four step optimization program' can be found here:
The tool I asked this question about originally is called 'Diagnostix', and is available for free download in step 1.
I will certainly appreciate your feedback!
You've covered a large number of ratios that address functional areas. However, a company should also keep an eye on their total debt levels. A Debt to Net Worth or Debt to Tangible Net Worth would be good ones for companies to keep an eye on every quarter with a long term goal of reducing that ratio.