In this post, I would like to share my top financial ratios, which I regularly apply to determine the health of a business
There are countless financial ratios around but it can get quite overwhelming at times. Have you ever walked into a restaurant and find a menu with countless pages of various dishes to go through. I feel most comfortable when a menu is a maximum of two pages long. It signals that the kitchen focuses on a few dishes that are cooked to order and perfected the more they are being cooked for the paying public. The same applies to financial ratios, the less you use the more focus you achieve and you will get a pretty good feel for them. Plus I seriously believe that the next 5 ratios give you a well - balanced picture of any company you choose to analyze. Get your popcorn ready here they come.
The power of ratio analysis
“Financial ratios should cover each aspect of a company's financial structure.They should assess its profitability, solvency and liquidity. The ultimate goal is to get a quick snapshot whether the company is well-managed and healthy"
1. ROCE (Return on capital employed)
In short words, the ROCE (Return on Capital Employed) shows how well a company uses its capital (Equity + Debt) to generate a return. But let me explain a bit more. Every business is essential working with two kinds of capital. The first one is capital or money provided by investors (such as friends and family, or professional financiers) and the second one is capital or money provided by professional lenders (such as banks). Both of these two capital providers would like to see that the business uses the money given to the company in the best possible way. In short, they want to see a return. Try to see it from the perspective of these two providers. The bank wants to be reassured that the business can first of all pay the interest on the borrowed money and secondly be able to pay back the money borrowed. The investors (such as your family who trusted you with their hard-earned money) want to know that one day you will pay them a dividend (or put simply: a reward for their trust in you). Therefore you take the EBIT (earnings before interest and tax) from the Income statement and put it in relation to the capital employed by investors and lenders. Here the formula:
EBIT / (Total Debt + Equity)
Strong companies show at least double-digit percentage figures, which means that the company makes good use of capital provided by shareholders and banks.
2. Cash generating efficiency: (CASH Margin)
Cash is king, I love this statement because it is so true in many ways. Cash is the gold standard of accountancy, rock-solid, and almost pure. Only with criminal intent can really falsify this position on the balance sheet by either falsifying bank statements or tinkering with bank reconciliations. But these kinds of shenanigans are worth a separate blog post.
“Cash is King. Unlike profit it can't be manipulated by financial wizardry such as accruals or other adjustments”
Back to the cash king; I hope we can agree that at the end of the day all that matters is what is left in the bank account. In my opinion, too much focus is WASTED on profit. It really is over-hyped and people are well-advised to really look closer at cash and scrutinize the bank account a bit more. We already have a powerful ratio that uses profit/earnings from the income statement and this I believe is enough. Lots of directors love the profit margin ratio which is net profit divided by sales. It essentially shows how much profit is left for each 1 Pound of sales. But I argue that this is not a true picture of profitability, precisely because profit does not equal cash. Therefore I substitute Net profit with Operating Cash Flow because Operating Cash Flow does factor in what cash the business generates from its core operations. Here the formula:
Operating cash / Sales
3. Leverage:
Finally, I want to look closely at the company's financial flexibility and security. As explained in the section about financial statements and the Balance Sheet, assets are financed by Equity and Liabilities expressed by the accounting equation: Assets = Equity + Liabilities.
With this ratio, I want to understand how much a company finances its assets through short-term and long-term debt, excluding cash. Here the formula:
Net Debt / Net Total Assets
A low percentage signals to me that the company does not rely on debt to finance its operations and manages to finance itself out of its operations and shareholder equity.
I sometimes also use the standard gearing ratio in conjunction with the above ratio to get a well-rounded picture.
Gearing ratio = LT debt + ST debt incl. bank overdraft) / equity. The result will tell me how much debt there is for each 1GBP of equity. The higher the ratio, the more dependent on debt a company is. When both ratios are high, it tells me that the company has to use a lot of its cash to pay off debt and therefore has less to invest in the business or pay to its shareholders. I like to see a moderately low ratio because debt is not necessarily bad. Still, a company should have enough breathing space to afford more debt to finance expansion projects or use for more productive uses.
Conclusion:
When you look at a company through the lens of these three ratios, you will get a pretty good picture of its strength. However, the key is to track these ratios over a more extended period to establish a trend.
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