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In this section we’re going to look at 5 ratio types, for analyzing and valuing a business.
- Growth Rates
- Financial Strength
- Management Effectiveness
The purpose of the ratio types should be fairly self explanatory. Growth rates are a measure of how much growth there is from one period to the next. This is not a measure of how fast we’re growing. We look at a given time frame, and see how did we do (eg) this quarter vs last quarter.
In order to continuously build the equity section of our balance sheet, as we saw in the first lesson, we want to see the gross revenue and the net income grow. We look at both, because if revenue is growing, but net income is stagnant, that could be a sign that variable costs are out of control. If the opposite is true, and net income is increasing, while gross revenues are the same, we need to look at that. It could mean we’re increasing profitability. We want to be sure that’s what it is. This is why we need to move on, and look at other ratios. We need to see the whole picture here.
If your company suddenly had to settle all of its debts, would you be able to? When we look at financial strength ratios, we’re looking at things like the Quick Ratio, and the current ratio. These measure liquidity. Then we look at debt to equity ratios. This helps us evaluate if the debt we’re taking on, is being put to good use. Is it enabling us to grow the business, and build the equity section of our balance sheet? It’s ok to take on debt, if it is helping your business. If it’s a band-aid, then that could be a problem. The last ratio in this section is an interesting one. It’s called, EBIT Interest Cover. This measures how easily we’re able to pay the interest on our debt. The lower this ratio, the more burdened a company is by its debt. A ratio of less than 1, indicates that a company is not generating revenues sufficient to satisfy its interest expense. This could be a sign that your company is in trouble.
How effectively are you managing your business? We’ll look at two ratios that give us an idea of the answer to that question. ROA (Return on Assets) gives us a measure of how effectively we are using our resources. If we invest the company’s cash into machinery and equipment, that help us to generate more revenues, and in turn more to the bottom line, then our ROA will increase. This is a sign that management is doing their job well.
Management also has a responsibility to the owners (and they may well be the owner). To that end we want to get a sense of how well the money you’ve invested into your business is paying off. For this, we look at ROE – Return on Equity.
This is simple. How profitable are we, and is that figure increasing or decreasing?
Here we look at Gross Profit Margin %, EBITDA % Margin (a truer measure of profitability), and Operating Margin. Most business owners make the mistake of just looking at net income. This can be very deceiving. We want to look at how well the business is operating on it’s own. This means without regard to Interest, Taxes, and non-cash expenses such as depreciation and amortization. In short, we remove the “BS” from the equation and see how the company truly stands the test of profitability.
One of my favorite things to look at, is a measure of how efficient our labor force is. Total revenue per employee. The math is simple, divide the revenues for a period by the number of employees who worked for you during that period. Assuming that your growth rates showed steadily increasing revenue for the period, then the question is, are you increasing in revenue per employee as well? A reduction in revenue per employee could indicate an inefficient labor force. It can also indicate that your employees are over burdened, so remember that you have to put as much context as possible on your analysis.
We’ll also look at the more common efficiency ratios, such as Receivable turnover, inventory turnover, and asset turnover.
All of these ratios are meaningful, only when put in a comparative context. You can use NAICS codes to compare your company to others like you, but I prefer to compare you to YOU. Meaning, we look at your own data in prior periods compared to now, and then compare that to where we want to be in one and two years from now.
If you take the time to compile and analyze this data, your chances of success are dramatically increased.
There’s all this talk about being a firm of the future. This is how you do it. You skyrocket your efficiency with apps and technology, so you have time to do this kind of analysis.