Gain valuable insight into your business with ratio analysis

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Gain valuable insight into your business with ratio analysis

Valuation experts regularly use financial ratio analysis to evaluate the financial
health of a company. These financial ratios are calculated from line items in a
company’s financial statements and are useful in examining historical trends and
gaining insight into how a business is likely to perform in the future.

A ratio analysis can help gauge a company’s ability to meet its current liabilities and
finance future growth, how well the company is using its assets, or how its
profitability compares with that of its industry peers.

There are four principal categories of ratios:

Liquidity ratios measure the ability of a company to meet current obligations.
Commonly used liquidity ratios include:

• Current ratio, or the ratio of current assets to current liabilities,
• Quick ratio, which only considers assets that can be readily liquidated, such
as cash and accounts receivable, and
• Receivables turnover, which estimates the average collection period for
credit sales.

Since current assets are generally used to pay short-term debt and make interest
payments, it’s essential that a company have adequate current assets. Liquidity ratios
illustrate a company’s need to improve liquidity or make more efficient use of its

Coverage ratios measure a company’s capacity to service its debt. One commonly
used coverage ratio is times interest earned, which measures a firm’s ability to meet
interest payments and indicates its capacity to take on additional debt. Another is
current debt coverage, which can be used to measure a company’s ability to repay its
current debt.

Before a company that already has significant bank debt seeks further financing, it
should calculate its coverage ratios and consider what message they send to potential

Leverage ratios can indicate the long-term solvency of a company. The long-term
debt-to-equity ratio represents how much debt financing is funding company assets.

For example, a ratio of one-to-one indicates that the company’s operations may be
meeting most of its capital requirements, and that debt financing is not a material
source of capital. Because cash isn’t necessarily needed to service debt, there may
be more available for potential shareholder distributions.

On the other hand, a long-term debt-to-equity ratio of five-to-one indicates that the
company requires significant debt financing to run operations. This may translate
into lower returns for shareholders and higher default risk for creditors. And,
because the company needs to make considerable interest payments, it has less cash
to meet its current obligations.

Operating ratios help appraisers evaluate a number of things, including
management’s performance and the effects of economic and industry forces.
Operating ratios can illustrate how efficiently a company is controlling costs,
generating sales and profits, converting revenues to cash, and using its fixed assets.

Benchmark company performance

Since ratio performance can vary from industry to industry, ratio results mean little
without appropriate benchmarks. Benchmarking a company to its competitors, its
industry averages and its own historical performance provides perspective on its
current financial health.

Valuation experts find information on appropriate benchmarks from rating agencies
like Dun & Bradstreet, government sources such as the Securities and Exchange
Commission, and industry trade associations. They also apply current ratios to the
company’s historical financial statements. This helps identify positive trends to be
maintained and negative trends that need to be addressed.

Basic understanding goes a long way

Ratios provide valuators with valuable insight into a company’s financial
performance and health. A basic understanding of these ratios will also help owners
and management make better, more-informed decisions about their company’s
financial future.

If you would like to speak with one of our Business Valuation advisors, please
contact John Gurley, [email protected], (207) 775-2387; or Art Marshall,
[email protected], (603) 669-7337.