Ratio Analysis – What’s Really Happening?

 

Written by John P. Shank, CPA, CGMA

In the manufacturing industry, it’s so important to know where your company stands, both operationally and financially.  While your company prepares financial statements on a regular basis, you may want to ask yourself, “Are you really getting the whole picture?”  In order to fully understand how your business is progressing, you need a relevant basis of comparison.  Key performance ratios can give you just that.

Companies need to set goals for what they want to achieve and then execute the proper steps to achieve those goals.  Financial ratios help management determine how well their business is progressing towards those goals by assessing what went well, what went right, and what went wrong.  By reviewing your company’s ratios regularly, you can pick up on trends and patterns over time to make sure you are staying on track to where you want to go.

Additionally, ratios provide data which allows management to benchmark the company against the top performers in the industry.  Trade associations such as the National Association of Manufacturers provide up-to-date financial figures and industry averages which can be used for comparison.  Trade journals, as well as the U.S. Department of Labor website, can also be helpful sources for relevant information.

So, what types of ratios should your company be using?  First of all, financial ratios are calculated by comparing two or more items on your balance sheet or income statement.  How and what type of information is used depends on you and your financial advisor.  At BMSS, we typically recommend using ratios such as:

• gross profit,
• debt to equity,
• rate of return,
• net income as a percentage of revenue,
• accounts receivable turnover,
• accounts payable turnover, or
• inventory turnover.

While these categories pertain more often to the manufacturing industry, every client in every industry should know which ratios are applicable to their company and use them as measurement tools.  Not only should these tools be used by management, but bankers will likely take some of these ratios into consideration when reviewing a business loan application.  You may not be calculating and monitoring key performance indicators and key ratios in your business, but I can promise you that your banker is.  Knowing these for your industry, knowing these for your individual business, and knowing the key ratios for your banker is vital to your lending relationship.

So, what should you take away from this?  The key point is to remember, and I cannot stress this enough, it is so important for efficiency and profitability to know what the KPI’s (key performance indicators) are for your business and then how to calculate them on a regular basis (at least monthly) and know what they are telling you about the health of your business.

Your BMSS professional can easily help you find out what key ratios are applicable for your business and what your banker needs.  We can help you in setting up the processes needed to get the information out of your internal system to calculate these on a regular basis.  It doesn’t require a lot of time and can prove to be invaluable in the long run.  Please contact us at (205) 982-5500 or visit our website at bmss.com.