Just as a wise patient undergoes regular medical checkups, your firm should have regular financial checkups. Why? Banks and even your vendors are already paying attention to your company's vital signs, so it makes sense for you to track them as well. Companies that have stronger health will generally pay lower interest rates on loans or receive preferential treatment from vendors.
The credit crisis has caused most lenders to tighten loan covenants. Companies may be required to maintain certain minimum levels of working capital, tangible net worth or debt service coverage ratios. In the past, lenders typically built some cushion into loan covenants to give companies some "wiggle room" before they fell out of compliance. In today's struggling economy, however, lenders are becoming less lenient. For this reason, it's critical that you monitor key financial ratios closely. It's also important to negotiate loan covenants with your lenders. To obtain the best terms, provide your lender with information that supports appropriate financial ratios for your business.
A Holistic Approach
Just as taking your blood pressure alone tells you little about your overall health, no single financial indicator tells the whole story about your company's well-being. There are numerous ratios and other metrics you can use, but it's important to select a manageable number of indicators that make sense for your company and measure its performance in various areas.
A good source of such benchmarking is the Annual Statement Studies published by the Risk Management Association (RMA). RMA, whose information comes from financial institutions across the country, is organized by industry code and size. Better sources for benchmarking are the trade associations specific to your industry, such as the Construction Financial Management Association or the Medical Group Management Association, just to name a few. The advantage to these types of studies is that information is much more tailored to your particular industry, and the information is often broken down geographically.
Generally speaking, financial ratios can be divided into four main areas: profitability, liquidity, leverage, and coverage. It's important to measure your company's performance in all four areas. Even though profitability is every company's ultimate goal, liquidity is critical in today's environment. Although your company seems to be thriving now, too much debt or inefficient use of capital or assets can signal trouble down the road.
Commonly Used Ratios
PROFITABILITY. Return on equity (net income / total net worth).
Generally, the goal of any company is to maximize the return on the equity invested in the business. But in some cases, a high ratio may indicate that the company is undercapitalized or has too much debt. Ultimately, high returns on equity mean higher risks for
shareholders.
LIQUIDITY. Current ratio (current assets / current liabilities).
The current ratio is a rough indication of a company's ability to pay its short-term liabilities with cash and other relatively liquid assets. The higher the current ratio, the greater cushion that exists for a firm to be able to pay current debts. This cushion is also known as working capital. However, differences in the composition and quality of a company's current assets need to be analyzed further, as this ratio alone does not distinguish between cash and inventory, for example.
LEVERAGE. Debt to equity (total debt / net worth).
The higher this ratio, the more leveraged the company is said to be. Basically, this ratio shows how much protection the equity owners are providing creditors. The higher the ratio, the greater the risk being assumed by creditors. Debt is generally defined as total liabilities, not just total interest-bearing debt.
COVERAGE. Interest coverage (income before interest and taxes / interest expense).
This ratio measures a company's ability to meet interest payments. A high ratio may indicate that borrower can easily meet the interest obligations of a loan. Additional coverage ratios consider principal payments coming due on debt in the next year. In today's environment, minimum coverage ratios have been increased.
Key Performance Indicators
Financial ratios are really just a subset of key performance indicators (KPIs). KPIs are specific to each industry and company and include non-financial measures such as customer satisfaction. For construction contractors, examples of KPIs might include unapproved change orders, underbillings or profit/fade analysis. Medical practices might analyze relative value units (RVUs) or support staff per physician. Each industry is different, and it is important to understand how each metric is defined, as there can be differences even within an industry.
Your Financial Health Plan
All companies should have a plan for collecting key financial and non-financial data, monitoring financial ratios and using these indicators to improve their business. By monitoring ratios and other key performance indicators, you can detect early warning signs of financial health problems before they do permanent damage.
Your financial advisor can help you put together a set of metrics that make sense based on the nature of your business and your company's particular circumstances. iBi
