Unleashing the Power of Ratios
Benchmarking the firmâ€™s performance
We all know financial ratios are a barometer of the health of a company. Now, let’s help our client’s unleash the power of these ratios to improve their businesses. Here’s how.
As we know, financial ratios are a fundamental barometer of the health of a business. However, many business owners and leaders focus solely on the income statement and balance sheet. In particular, many small business owners do not fully understand the relationship between financial ratios and the operations of their business.
There is a real opportunity for business valuators to help business owners understand the underpinnings of financial ratios. This will help your clients better their business operations, improve their financial ratios, and ultimately increase the value of their business. This service is especially valuable for those having their business valued for the purposes of financial, strategic, or exit planning. It is critical information for them to utilize as they continue to grow and foster their business for the longer term payoff.
How can you help your clients? Listed below is a sampling of ratios and suggestions on how your clients might improve them. It is important to note that improving many of these ratios can have a positive effect on other related ratios, many of which are not listed:
Current Ratio: Strong cash management policies and procedures can improve this ratio. Have your client use sweep accounts, credit cards, and other cash-management tools available through their bank. They should monitor and reduce cash usage for non-operating assets, ownerâ€™s draw, or other non-essential cash outflows which reduce liquidity.
Receivables Turnover: Your client should actively monitor and manage accounts receivables. They should be billing correctly and receiving payment in a timely manner. They can also consider tighter payment terms and/or more aggressive collections to accelerate cash coming into their accounts. Your client should be sure that their delivery system is efficient and timely to facilitate quick payment from customers.
Days Inventory: Have your clients review inventory-buying and management systems to ensure the levels of inventory reflect their sales expectations. There should be adequate and appropriate stocking levels for all inventory items. They should liquidate excess or obsolete inventory to not only improve this ratio, but also increase liquidity.
Payable Turnover: Your clients should negotiate longer payment terms with vendors whenever possible to delay money flowing out of their accounts. They should also negotiate price with their vendors and take advantage of pricing discounts, when available.
Pre-tax Net Profit Margin: Improving the net profit margin means increasing sales at a rate faster than the rise of operating costs (or, holding sales constant while decreasing operating costs). Your client should consider re-evaluating their pricing strategy and increasing prices where possible. They can improve gross margins by improving product line profitability, as well as decreasing their supply chain costs by renegotiating with suppliers or finding new suppliers to reduce the cost of materials, supplies, and shipping. Additionally, they should consider passing some costs, such as shipping, onto customers. Your clients can also reduce overhead costs and implement tight expense controls as well as improve productivity to improve this ratio.
Return on Assets: If your clients improve efficiency in operating their plant and equipment, then they will improve their return on assets. They should get rid of any unproductive assets that they still have on the books. They can reduce equipment costs by renting or leasing instead of buying a piece of equipment that may sit idle if their needs change. Reducing inventory and increasing revenue without a corresponding increase in assets will also improve this ratio.
Asset Turnover: Clients should fully utilize their existing assets. This might mean selling more product and adding an additional shift to produce those products. They should also find ways to use their assets more efficiently, such as increasing machine output, improving processes, retraining, setting quotas or ensuring delivery trucks run full. Selling non-operating assets and leasing equipment will also improve this ratio.
Times Interest Earned: Clients should regularly review their debt obligations to be sure they have the best interest rates available. A reduced debt load, lower rates, or extended terms will all improve this ratio. Clients should also consider converting a traditional loan to a line of credit and accessing the funds only when needed.
Return on Equity: Improving a companyâ€™s net profit margin and asset turnover will improve your clientâ€™s return on equity as will strategies to decrease a companyâ€™s tax burden. Likewise, they can increase their debt, thus reducing the equity component of the company. However, this must be balanced with increased interest and repayment obligation which will adversely affect other ratios.
We know that taken together, financial ratios provide a comprehensive picture of the health of your clientâ€™s business. Banks and funding sources will look these financial ratios, and it is imperative to show improvement or address the downsides the analysis reveals. Now, take it one step further and help them improve their business by offering suggestions which will help them not only improve their business, but also future valuations.
Kelly Deis is the president and founder of Soundpoint Consulting, a business consulting and valuation firm in the Seattle area. You can contact Kelly at firstname.lastname@example.org or (206)842-4922. In addition,, visit www.soundpointconsulting.com to obtain more information about the services provided by Kelly.