3.5 Financial Ratio Analysis

Learning Objectives

By the end of this section, you will be able to:

Sections 3.2 through 3.4 opened the three financial statements one at a time. This section is where they come back together — not by reading all three cover to cover every month, which nobody actually does, but by pulling a handful of numbers out of them that you can track, compare, and explain in a sentence.

3.5.1 Why ratios, when you already have the statements

Reading all three statements carefully every month is more than most small business owners will actually do. It is also more than a banker reviewing a stack of loan applications will do. Both of them need a faster way in.

In addition to reviewing the financial statements to make decisions, owners and other stakeholders use financial ratios to assess the financial health of the organization. Ratios are a common, easy, and useful way to analyze the statements — a small number of figures that condense several pages into something you can track month over month and explain out loud.

The financial statements provide feedback to owners about financial performance and financial position, which helps them make decisions about the business. Ratios are what make that feedback usable week to week.

There is also a comparability problem that ratios solve. Section 3.3 noted that you generally should not compare the balance sheets of two different companies directly, because their sizes differ — you would not compare a local retail store with Walmart. Working capital, for instance, is a dollar amount, and a dollar amount can mislead across business sizes: $1,000 is far more material to an independent local movie theater than it is to a national chain. Using percentages or ratios lets financial statement users compare small and large businesses on the same terms. It also lets you compare your own business against last year without being fooled by the fact that you are simply bigger now.

Professional analysts have made the same move. As faith in earnings-based metrics fell in the wake of Enron and WorldCom, many analysts gravitated toward the cash flow statement, and companies are now regularly evaluated on free cash flow yield and other measures of cash generation. Ratios of this kind let a user analyze statement data to see a company's ability to pay current debt, and to judge whether operating cash flow can sustain the business as a going concern.

The four ratios in this section. Each one pulls from a different place and answers a different question.

Gross margin and net margin come from the income statement, and they measure profitability. The current ratio comes from the balance sheet and measures liquidity. Debt-to-equity also comes from the balance sheet and measures leverage — how the business is financed. Together they cover the three questions a lender asks: does it earn, can it pay, and who really owns it.

3.5.2 Profitability: gross margin and net margin

Profitability ratios come off the income statement. There are two of them here, and the useful skill is reading them as a pair rather than one at a time.

Gross margin

Gross margin starts with a concept from the multi-step income statement in §3.2: cost of goods sold.

For a business that sells physical products, cost of goods sold — sometimes called cost of sales — is an expense reflecting the cost of the merchandise that customers purchased during the period. It is what the business paid for the inventory items that were then sold.

The mechanics are worth being precise about, because they are widely misunderstood. Suppose a convenience store pays $2 in cash for a box of cookies on Monday and sells it to a customer for $3 on Friday. The income statement recognizes revenue of $3 — the increase in net assets created by the sale — and cost of goods sold of $2 — the decrease in net assets from the inventory leaving. Both are recorded on Friday, when the sale took place and the inventory was removed, not on Monday when the cash was paid. This is the matching principle from §3.2 doing its work: the cost is matched to the revenue it produced.

The difference between revenue and cost of goods sold is the company's gross profit, also called gross margin or markup. It is one of the figures studied most carefully by decision makers, and expressing it as a percentage of sales is what turns it into a ratio you can track.

Definition 3.5.1 — Gross profit margin ratio: what survives the cost of the goods is what is left to run everything else.

The larger the margin, the more room the company has to reinvest in the business, pay down debt, and return money to its owners.

In plain language: gross margin is the answer to "how much room do I have?" If it is 39%, then every $100 of sales leaves $39 for everything else. If your fixed operating costs run $4,000 a month, you need roughly $10,250 of sales a month before you break even — and if gross margin drops to 30%, that same $4,000 of costs now needs about $13,300 of sales. A few points of gross margin change the whole shape of the business, which is why a falling gross margin is one of the most important signals a product business has.

Note that gross margin is only meaningful if the income statement is prepared in the multi-step format. A simple income statement does not separate cost of goods sold from operating expenses, so gross margin cannot be read off it at all. A service business with no inventory may not have a meaningful cost of goods sold in the first place.

Net margin

Where gross margin looks at what is left after the cost of the goods, net margin looks at what is left after everything.

Net income is the figure the income statement arrives at after revenues and gains less expenses and losses — the bottom line from §3.2. Dividing it by sales converts it from a dollar amount into a percentage that can be compared across periods and across businesses of very different sizes.

Definition 3.5.2 — Net profit margin: the same sales dollar after the second cut, with only 8 cents left.

In plain language: net margin is the answer to "what do I actually keep?"

Reading the two together

The pair is far more informative than either one alone, because the gap between them is the cost of running the business.

The second row is the most common diagnosis in a struggling small business, and it is one an owner can act on quickly. It is also the reason a lender asks for both figures rather than just the bottom line: the bottom line tells you there is a problem, and the pair tells you where it is.

Two cautions follow from §3.2. First, these ratios are built on net income, and the importance of any single balance should never be overemphasized — a full evaluation looks at the entity as a whole. Second, both ratios are computed on accrual figures, so a strong net margin says nothing directly about whether the cash actually arrived. That is what the current ratio and the statement of cash flows are for.

3.5.3 Liquidity: working capital and the current ratio

Profitability tells you whether the business earns. Liquidity tells you something more immediate: whether it can pay what it owes this year.

What liquidity means

Before the ratio, the concept.

Definition 3.5.3 — Liquidity: assets reach cash at different speeds, in the order the balance sheet already lists them.

Assets differ in how quickly they can be converted. Among the most liquid are accounts receivable and, for a merchandising or manufacturing business, inventory. Receivables are highly liquid because they represent goods or services already sold that will typically be paid within thirty to forty-five days. Inventory is less liquid than receivables, because the product must first be sold before it generates cash — through either a cash sale or a sale on account. But inventory is more liquid than land or buildings, because under most circumstances it is easier and quicker to find someone to buy your goods than to find a buyer for real estate.

This is exactly why the balance sheet lists assets in order of liquidity, as §3.3 noted: cash first, then investments expected to be sold soon, then receivables, then inventory, then the long-lived assets.

Working capital

The starting point for understanding liquidity ratios is working capital.

Definition 3.5.4 — Working capital: the cushion between what is due within the year and what is on hand to meet it.

Recall from §3.3 that current assets and current liabilities are amounts generally settled in one year or less.

• A positive working capital amount is desirable. It indicates the business has sufficient current assets to meet its short-term obligations and still has financial flexibility.
• A negative amount is undesirable. It signals that the business should pay particular attention to the composition of its current assets — how liquid they really are — and to the timing of its current liabilities.

It is unlikely that all current liabilities will come due at the same time. Even so, the working capital figure gives stakeholders an indication of the firm's ability to meet short-term obligations, and it does so for businesses both small and large.

Working capital carries the size limitation described at the top of this section: it is a dollar amount, and dollar amounts are hard to compare across businesses. Caterpillar disclosed working capital of $9.790 billion at the end of 2010 — current assets of $31.810 billion less current liabilities of $22.020 billion. That number is meaningless next to a landscaping business's working capital of $4,000, not because one company is healthier, but because the two are not on the same scale.

The current ratio

The current ratio is closely related to working capital, and it solves the scale problem by expressing the same relationship as a ratio rather than as a dollar amount.

Definition 3.5.5 — Current ratio: how many times over the short-term resources cover the short-term obligations.

It uses exactly the same two figures as working capital, and the interpretation is similar:

• A ratio greater than 1 indicates the firm can meet its short-term obligations with a buffer.
• A ratio less than 1 indicates the firm should pay close attention to the composition of its current assets and to the timing of its current liabilities.

Both figures reflect a company's liquidity — its ability to pay debts as they come due and still have enough monetary resources available to generate profits in the near future. Investors and creditors frequently calculate, study, and analyze both. They are vital signs that help indicate the financial health of a business and its future prospects, in much the way a doctor beginning a physical examination checks heart rate, blood pressure, weight, and temperature, looking for any sign of a serious change. If a person's blood pressure has increased significantly since the last visit, the doctor investigates with special care. Ratios work the same way, and the next example is a case where the change carries all of the information.

In plain language: the current ratio is the answer to "if everything I owe in the next year came due at once, could I cover it out of what I already have or expect to collect?"

One caution follows directly from §3.3 and §3.4. Current liabilities include taxes payable — the sales tax and payroll tax the business is holding for government agencies. Those amounts belong in the denominator, and correctly so: they are real obligations coming due. An owner who leaves them out because "that money is just passing through" will compute a current ratio that overstates the business's position, and will be the last person to know it.

3.5.4 Leverage: the debt-to-equity ratio

Profitability tells you whether the business earns. Liquidity tells you whether it can pay its bills this year. Leverage tells you something different: how the business was funded, and how much risk that funding choice carries.

Why liabilities get this much attention

Investors, creditors, and other interested parties who analyze a company usually spend considerable time studying the data provided about liabilities, often focusing on current liabilities. The reason is direct: liabilities represent claims to a company's assets. Debts must be paid as they come due or the entity risks serious consequences. Missed payments may damage a company's ability to obtain credit in the future, and if obligations are not met, even bankruptcy can quickly become a possibility.

To stay viable, an organization has to manage its liabilities carefully and generate enough cash on an ongoing basis to meet all required payments. Virtually no other goal is more important, to company officials and external decision makers alike.

The general principle a lender applies is this: the larger a liability total is in comparison to the reported amount of assets, the riskier the financial position. The future is always cloudy for a business when the size of its debts begins to approach the total of its assets.

The debt-to-equity ratio

One vital sign often studied by decision makers puts that comparison into a single number.

Definition 3.5.6 — Debt-to-equity ratio: how much of a business was funded by creditors rather than by its owners.

The resulting number indicates whether most of a company's assets came from borrowing and other debt, or from its own operations and its owners. A high debt-to-equity ratio indicates that a company is highly leveraged.

Real companies vary widely, and there is no single correct strategy. The four below were all healthy, well-known businesses at the time these figures were reported.

The ratio indicates a company's policy toward debt, but other factors are involved. In some industries debt levels tend to run higher than in others, and individual responses to economic conditions affect some companies more than others. A number that is normal for one industry may be alarming in another, which is why the ratio is a question to ask rather than a grade to assign.

What leverage actually buys — and costs

To interpret the ratio you need to understand why a business would deliberately carry debt at all. There are three advantages, and the third is the important one.

Interest is tax deductible. A company essentially recoups a significant portion of its interest costs from the government. Xerox incurred interest expense of $592 million, which reduced its taxable income by that amount; at an assumed 35% effective tax rate, its tax bill fell by $207.2 million, so the net cost of borrowing for the period was $384.8 million rather than $592 million.

Debt can be eliminated. Liabilities are not permanent. If the economic situation changes, a company can rid itself of all debt by making payments as each balance comes due. By contrast, if money is raised by issuing ownership, the new owners can maintain their stake indefinitely.

Financial leverage. This is the biggest advantage commonly linked to debt, and it is the one the ratio is really measuring.

Definition 3.5.7 — Financial leverage: the interest bill does not move when earnings do, so borrowing multiplies the result in both directions.

If a company borrows $1 million at 5% per year, annual interest is $50,000. If that $1 million generates a profit of $80,000 — added revenue minus added operating expenses — net income rises by $30,000 using funds provided entirely by creditors. The owners contributed nothing additional and are $30,000 better off.

Over the decades many companies have adopted a strategy of being highly leveraged, meaning most of their funds come from debt financing. If the business is profitable, the owners can earn large profits with little or no investment of their own. Unfortunately, companies that take this approach face a much greater risk of falling into bankruptcy, because of the large amounts of interest that must be paid at regular intervals whether or not the business had a good year.

That is the trade-off the ratio measures. Relying on debt financing makes a company more vulnerable to bankruptcy and other financial problems, while also giving the owners a chance at higher rewards. A high debt-to-equity ratio is not automatically bad and a low one is not automatically good — but the higher it is, the less room for error the business has, because the interest bill does not shrink when sales do. The next example runs the arithmetic in both directions so you can see exactly where the risk lives.

A note on interest coverage

A related measure worth knowing by name is times interest earned, often abbreviated TIE. Debt normally becomes a risk only if the interest cannot be paid when it is due, and this calculation helps measure how easily a company has been able to meet its interest obligations out of current operations. Where debt-to-equity asks "how much debt is there?", times interest earned asks "can the business comfortably service it?" — often the more urgent question for a small business, whose lender cares less about the size of the loan than about whether the monthly payment will clear.

In plain language: debt-to-equity is the answer to "how much of this business is really mine, and how much belongs to the people I owe?" A ratio of 0.92 means creditors funded slightly less than the owners did. A ratio of 4.50 means creditors funded four and a half times what the owners did, and every dollar of profit has to clear a large interest bill before any of it reaches the owner.

3.5.5 Reading a statement for red flags

The previous subsections computed ratios. This one is about reading them — and reading the statements around them — for signs of trouble, either in your own business or in a set of statements someone has handed you.

A red flag is not a verdict. It is a place to investigate with special care. Each of the signals below is a legitimate result in some circumstances and a warning in others, and the skill is knowing which questions the signal raises.

Red flag 1 — Cash flow does not track net income

This is the most consequential signal, and the one this chapter has been building toward. A company whose statement of cash flows shows significantly less cash inflow than the net income reported on its income statement may be recognizing revenue for which cash will never be received from the customer, or it may be underreporting expenses.

For a small business the interpretation is usually less dramatic and just as important: profitable months that consistently produce weak or negative operating cash flow mean the profit is being converted into receivables and inventory rather than into money. Section 3.4 walked through exactly how that happens.

What to ask: Are customers paying more slowly than they used to? Is inventory building up? Is the revenue real?

Red flag 2 — Absent or negative free cash flow

Definition 3.5.8 — Free cash flow: operating cash less the planned spending, and here it lands below zero.

For the Propensity Company example from §3.4, the arithmetic runs as follows.

The absence of free cash flow is an indicator of severe liquidity concern, and it can be an early indicator that a company may not be able to continue operations.

But it is genuinely ambiguous, and this is exactly why a red flag calls for investigation rather than a conclusion. The same negative figure could reflect a one-time occurrence in a year when a large capital investment was planned and financed from cash reserves built up by earlier years' profits. In that case the negative free cash flow is not a concern at all — it is a deliberate, funded expansion, the same pattern Walgreen showed in §3.4.

What to ask: Was this a planned investment with a funding source behind it, or is the business simply spending more than it generates?

Red flag 3 — Burn rate and the composition of current liabilities

Investors and creditors look at current liabilities in part to calculate a company's burn rate.

Definition 3.5.9 — Burn rate: how fast the reserve falls, and how many months of operation are left.

Burn rate indicates how quickly the company is consuming its cash. Many start-ups have a high burn rate because of spending to launch, which produces low cash flow; at first, start-ups typically do not generate enough cash to sustain operations at all.

This is why the proper classification of liabilities as current matters so much. Correct reporting of current liabilities helps decision makers understand the burn rate and how much cash the company needs to meet both its short-term and long-term obligations. A creditor's, investor's, or owner's understanding of specific cash needs is what supports good financial decisions.

What to ask: How many months of operations does the current cash position actually fund? Are all current obligations — including taxes payable — on the balance sheet?

Red flag 4 — Receivables aging

One indication of a company's financial health is its ability to collect receivables in a timely fashion. Money cannot be put to productive use until it is received, which is why businesses work to encourage customers to pay quickly. There is a second reason as well: the older a receivable becomes, the more likely it is to prove worthless.

Interested parties both inside and outside a company frequently monitor the time taken to collect. Quick collection is normally viewed as desirable, and a slower rate can be a warning sign of possible problems. As with most generalizations, exceptions exist, so further investigation is always advised.

Definition 3.5.10 — Age of receivables: three collection periods on one day scale, where the change matters more than the level.

Credit sales are used if they are known, but the total sales figure often serves as a substitute because of availability. Sales are first divided by 365 to derive sales per day, and that daily figure is then divided into the reported receivable balance.

By itself an age-of-receivables figure is neither good nor bad, but a significant change in it will be quickly noted by almost any interested party. A business whose collection period drifts from 29 days to 50 days has a developing problem whether or not its income statement shows one.

What to ask: Is the collection period lengthening? Does it match the payment terms actually offered?

Red flag 5 — A deteriorating trend in any vital sign

The Avon figures in Example 3.5.3 make the general point. A current ratio of 1.42 is not itself alarming. A current ratio that fell from 1.84 to 1.42 in a single year is worth investigating, because the direction is the information.

This applies to every ratio in this section. A single figure is a snapshot; a trend is a story. Because you generally cannot compare your balance sheet directly against another company's, your own prior periods are the most reliable comparison you have — and they are the comparison that will make a lender most confident that you understand your own business.

Bringing it together

Every signal above has a benign reading and a concerning one. The table collects them for reference.

None of the right-hand entries is proved by the ratio. Each is a hypothesis the ratio makes visible, and the value of running these numbers monthly is that you form the hypothesis while there is still time to act on it. That is the practical purpose of everything in this chapter.

Chapter 7 returns to this material from the other direction: how to summarize these figures in plain language for a lender, a partner, or an investor, and how to tell which questions belong to a CPA rather than to you.

Problem Set 3.5

Key Terms