Understand Your Financial Ratios

“A little learning is a dangerous thing.” This famous saying by Alexander Pope means that a small amount of knowledge may give people the idea that they are already experts on the topic. The same may be said with our basic financial ratios.

Financial ratios are proportions calculated from data derived from financial statements. Many of them are from the balance sheet and income statement. They serve to give us an idea of a business’ status or performance. However, most people who are not graduates of business courses know nothing about them. This is inconvenient, to say the least, but at least they can ask those who are knowledgeable.

What is more alarming is that business graduates usually study them by rote and fail to see the proper application of the theories. Most do not see the conditions that must be present in order for the formulas to be accurate. Believing they know more than they do, many of them make decisions based on incomplete information.

To illustrate the use of a financial ratio clearly, we will use a drugstore as an example. You may want to see if the business has the means to pay its debts. One of the most used ratio to learn this is the Current Ratio. If you are to use the Current Ratio to see if it is liquid you must know how cash flows within this type of business.

Being liquid is important because it means the business has the means to pay for its debts.

Traditionally, most books cite a current ratio of two as a comfortable amount. Now, you arrive at the current ratio by dividing current assets by the current liabilities. In accounting, current assets mean the asset can be converted into cash within one year while current liability means the debts that are due to be paid within one year.

On the average, a current ratio of two is alright but you must look into how soon your actual inventory can be turned into cash. If you are full of slow moving merchandise, it may take many months for most of them to be sold. Unfortunately, the current liabilities of a drugstore are usually trade credits given by suppliers that are due in 30 days. This simple observation alone will show that a current ratio of two may be too low for comfort.

Using the financial ratio called quick ratio (also called acid ratio) is more conservative since inventory, which is often slower to turn into cash, is deducted from the current assets. A quick ratio of one is generally recommended, this means for every peso of current liability there is one peso of current assets (less the inventory) to pay for it. Again, a consideration of both the actual ease of conversion to cash of the current asset and the actual due date of the liability must be done. If your current asset is mostly cash then that is better than if they were receivables still be collected.

Another financial ratio that is often used in stores is the inventory turnover ratio. This measures how often you roll over your inventory. You get this by dividing cost of goods sold by the average amount of inventory at cost. Here the usual text book advise is that the faster you turnover your stock, the better it will be.

There are two basic errors usually committed in analyzing the ideal inventory turnover ratio. The first is neglecting to measure the long term impact of stock outs when you reduce your inventory levels. But the second blunder, which is failing to segment your inventory, is less known and more harmful.

In the case of drugstores, generic items must be separate from branded medicine because the gross profit difference between the two is enormous. The turnover for branded medicine must be faster as the profit there is very little. On the other hand, it is justifiable to have a slower turnover for generic medicine since it has huge margins.

Generally, it would be far better to compare your financial ratios to industry standards than to rely on what text books recommend. The data on the textbooks are composed of averages from different industries that are presumably obtained from other countries. Unfortunately, there may be a lack of publicly available data in which case you must do your own careful study of what should be the ideal ratios for your company.

Financial ratios are critical in determining the financial health of a company. They are the key indicators that can guide you on what course of action to take. However, it is not enough to simply memorize the formulas, you must also understand how to use them.

*Originally published by the Manila Bulletin. Written by Ruben Anlacan, Jr. (President, BusinessCoach, Inc.) All rights reserved. May not be reproduced or copied without express written permission of the copyright holders.