An entrepreneur wants to know the financial health of customer/suppliers in order to make informed business decisions. A manager in turn needs financial metrics to direct his team better while an investor makes it an important criterion for his investment decisions.
Financial performance analysis entails a full diagnosis of the profitability and financial soundness of a business. Basically, it involves analyzing company data available in the three financial statements – the Balance sheet, the Profit & Loss Account and the Cash-flow statement.
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Data from these financial statements are compiled by cloud-based company data providers in a user-friendly format. By leveraging these data, you can analyze the financial performance of a company.
Broadly, there are four categories of financial ratios to look at:
Liquidity ratio
It measures the extent of liquidity a company has to meet its debt obligations.
One of the popular measures is the current ratio – which is calculated by dividing current assets by current liabilities. The higher the ratio, the better is the company’s liquidity.
A ratio of one or more is generally acceptable; it however varies across industries. A lower current ratio than the industry average could mean you might want to review your credit/collections policies. Too high a ratio also pinpoints underutilized capital.
Solvency ratios
Solvency ratios give a peep into the long-term solvency of the company. The debt-to-equity ratio is calculated by adding all of the company’s liabilities and dividing it by shareholder’s equity.
Lower the debt-to-equity ratio better is the company’s financial health. A low ratio also gives the company the elbowroom to borrow more, if need be, to fund its growth path.
On the other hand, a company with a debt-equity ratio of more than two is considered riskier. Again, this ratio needs to be analyzed from an industrial perspective.
One challenge with only reviewing company debt is that they do not tell you anything about the company’s ability to service it. This is exactly what the interest coverage ratio aims to fix. It is calculated by dividing earnings before interest and taxes by the company’s interest expense. The higher the ratio, the more poised it is to repay its debts while a ratio below one indicates a precarious financial position.
Efficiency ratios
It measures the company’s ability to use its assets to generate income. The inventory turnover ratio indicates how long it takes for inventory to be sold and replaced during the year. The longer the stock sits on company shelves, the more are its costs.
It is calculated by dividing the cost of goods sold by the average inventory for a period. Similarly, account receivable turnover tells how often it is collected and paid.
Accounts payable turnover: Measures how fast you pay off your creditors
Total asset turnover: Showcases how well you use your assets to generate revenue
Profitability ratios
Popular profitability ratios are
Net profit margin – How much a company earns after taxes relative to its sales? A company with a higher net profit margin than its peers is usually more efficient and dynamic.
Operating profit margin – How efficiently a company generates profit from its core operations before paying its interest and taxes?
Return on Equity indicates how much are shareholders earning on their investments. It is calculated by dividing Profit After Tax by the shareholder’s equity.
Return on Assets (ROA) specifies how well the management is utilizing the company’s resources or assets. Capital-intensive industries usually tend to have low ROA than the service industry. It is calculated by dividing net profit by average total assets.
There are many more financial ratios for making advanced analysis. All need not be looked at in isolation but analyzed in conjunction to get a big picture. Time-series analysis and comparison vis-à-vis industrial benchmarks in turn could help gain deep financial insights.
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