What do investing, auditing, determining business valuation and even procurement have in common? These functions all require meticulous analysis of financial information. The trouble is that a company’s financial statements contain an incredible amount of numbers and figures, which can easily lead to confusion and intimidation.
Enter: Financial ratios
Financial ratios are comparative measures—usually expressed as a percentage—used to assess a company’s financial health.
The metrics used are taken from a company’s financial statements, primarily the income statement and the balance sheet. Financial ratios convert financial information to a standardized format so companies can easily be compared against each other and the broader industry.
Many industries regularly use financial ratios. Accounting, business valuation, banking, procurement, consulting—professionals in these industries use financial ratios to identify red flags and areas of concern, tailor projections (such as cash flow and share performance), analyze credit, assess risk, and strategize, among many other things.
Navigating Financial Statements
Financial ratios have myriad uses, including converting financial information to manageable formats. Understanding the underlying data and how ratios are calculated will make applying them easier and more intuitive.
So, where does financial information come from?
The Securities and Exchange Commission (SEC) requires public companies to disclose their financial standing by filing several forms.
Of the required filings, a company’s annual 10-K filings are the most comprehensive. A 10-K tells the story of a company’s performance over the course of a fiscal year by presenting and discussing financial benchmarks and other milestones. The 10-K is home to the three major financial statements used in financial ratios: the income statement, balance sheet and cash flow statement.
- The Income Statement summarizes a company’s revenue and expenses on a quarterly or yearly basis. Investors, lenders, procurement teams and other professionals use the income statement to gauge profitability. A company’s earnings, or profit, have long been used as a quick measure of success and determinant of share prices, making the income statement a key focus in financial press releases.
- The Balance Sheet provides a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. As the name suggests, all items on this statement balance out.
Assets = Liabilities + Shareholder’s Equity
While this equation is taken care of, there’s still some heavy lifting to do when analyzing a balance sheet. That’s where financial ratios come in—they show you how the individual line items of a balance sheet relate to each other. Consulting a company’s balance sheet is essential when considering debt exposure and other risks that impact financial standing. - Cash Flows are also recorded in companies’ 10-Ks and annual reports. The Cash Flow Statement (CFS) summarizes the cash and cash equivalents that flow in and out of a company. This statement, often considered the most intuitive of the three main financial statements, pulls information from the balance sheet and income statement to paint a fuller picture of a company’s transactions.
While the SEC keeps a database of 10-K filings, there are other places to find this financial data, too. Most public companies make it easy for their investors with convenient links to annual reports on their websites. A company’s annual report addresses shareholders directly and provides them with a visually appealing, marketable version of the 10-K.
Since 10-K filings and annual reports can be dense and wordy, software developers, market research companies and other third-party platforms have created more tailored solutions for financial analysts and other professions that rely on this data. As a result, financial statements can now be accessed outside of the SEC database and company websites. Choosing a third-party platform that prioritizes financial statements can carve an easier path to the numbers that matter.
Most Important Financial Ratios
While seasoned professionals may be able to draw conclusions about a company simply by looking over their financial statements, they use financial ratios to document their findings. Financial ratios manipulate the line items on a company’s income statement, balance sheet and CFS to paint a clearer picture of the financial health, operating efficiency and level of risk a company presents.
While there are many financial ratios, they broadly fall into the following categories: Liquidity, Coverage, Leverage and Operating ratios.
Liquidity Ratios
Liquidity ratios illuminate a company’s ability to meet its short-term debt obligations with accessible cash.
Think of it this way: a company that does not have enough liquidity (i.e. quick access to cash) to pay its short-term liabilities would have to sell its assets at unfavorable prices and conditions to raise money. Some of those unfavorable prices and conditions include selling an asset at below market value, borrowing at high interest rates or selling part of the company.
Some key liquidity ratios include:
- Current Ratio – This ratio, also known as the working capital ratio, indicates a firm's ability to pay liabilities with current assets. The larger the ratio, the more liquid the business.
- Receivables Turnover Ratio – This ratio measures the number of times accounts receivable turn over during the year. It can be used to measure a company’s effectiveness in collecting its receivables from its customers.
- Collection Period for Accounts Receivable (Days) – This figure expresses the average number of days that receivables are outstanding and may indicate the extent of a company’s control over credit and collections.
- Revenue to Closing Inventory (Inventory Turnover) – This ratio, also known as inventory turnover, indicates the average liquidity of a company’s inventory or whether a business has over- or under-stocked inventory. It is often calculated using "cost of sales" rather than "total revenue."
- Days' Inventory – Dividing the inventory turnover ratio into 365 days provides the average number of days inventory is held by a company before it is sold.
- Sales to Working Capital – Working capital reflects a company’s ability to finance current operations and is a measure of the margin of protection for current creditors. When used in this equation, the results reveal how efficiently working capital is being used.
Coverage Ratios
Coverage ratios are used to measure a company’s ability to meet its short-term financial obligations.
Say a company’s sales take a sudden nosedive. Coverage ratios can help in understanding how much room the company has to take an unexpected hit. Companies with higher coverage ratios should have an easier time making interest payments on their debt or paying dividends.
- Interest Coverage Ratio – Also known as “times interest earned,” this ratio calculates the average number of times that interest owing is earned, indicating how well a company can cover its interest obligations on debt.
Leverage Ratios
Leverage ratios measure a company’s ability to meet long-term financial obligations and can be used to gauge a company’s financial strength, especially during periods of adverse economic conditions.
Leverage ratios focus on the long-term health of a company relative to its capital in the form of debt.
Companies can finance growth using debt, but there comes a tipping point when racking up debt becomes too risky. Uncontrolled debt levels cause credit downgrades and may even cause creditors to seize business assets to satisfy debts.
- Debt to Equity – This ratio indicates a firm's ability to pay its long-term debts. The debt to equity ratio also provides information on the capital structure of a business by showing the extent to which a firm's capital is financed through debt.
- Debt Ratio – This ratio indicates a firm's ability to pay its long-term debts by comparing the amount of outstanding debt with the amount of capital. The lower the ratio, the more solvent the business.
- Net Fixed Assets to Equity – Net fixed assets represent long-term investment, so this percentage indicates relative capital investment structure.
Operating Ratios
Operating ratios are used to gauge the day-to-day operational performance of a company. The results are used to judge the efficiency of a company’s management and its ability to keep operating expenses in check relative to net sales.
Operating ratios are only helpful when comparing different time periods. When looking at operating efficiency from one month to the next, or one quarter to the next, trends will arise. A downward trend means that operating expenses are shrinking as a portion of net sales—a sign of success.
- Revenue to Equity – The revenue to equity ratio measures a company’s total revenue compared with investments used to generate revenue. The ratio provides an indication of the company’s economic productivity of capital.
- Net Profit to Equity – This percentage indicates the profitability of a business, relating income to the amount of investment committed to earning that income. This percentage is also known as "return on investment" or "return on equity (ROE).” The higher the percentage, the relatively better profitability.
- Return on Assets (ROA) – The return on assets ratio measures a company’s ability to generate profit from its assets. A higher ratio indicates that a company is better able to convert its investments into profits.
How to Apply Financial Ratios
At this point, you may be wondering how these ratios are used and who’s using them. Earlier, we said that financial ratios are needed in many different industries, and it’s true. There are many applications for financial ratios. Let’s dive in.
Commercial Banking
Commercial banks make money by earning interest from loans, especially business loans which can range in value from tens of thousands to millions of dollars. But bad loans can drive up credit risk fast. That’s why commercial banks use financial ratios to thoroughly assess lending risks before making any agreements.
Commercial bankers use financial ratios to:
- Measure liquidity in potential borrowers
- Understand the level of debt a company has compared with assets
- Assess profitability and risk exposure in potential borrowers
- Conduct credit analysis for benchmarking industry norms
- Conduct annual credit reviews for future and current clients
- Identify triggers and performance tolerance in portfolios and prospecting processes
Which ratios do commercial bankers use most?
- Current Ratio
- Debt to Equity
- Liabilities Ratios (current liabilities, long-term liabilities)
- Interest Coverage Ratio
- Return on Assets (ROA)
Let's take a closer look:
Debt Ratio
For commercial banks, understanding a potential borrower’s financial standing and overall risk is key. Lending to a company already leveraging high amounts of debt can be too risky for a commercial bank. As a result, the debt ratio is an important and routinely used ratio by commercial banks.
Using the debt ratio, commercial banks can quickly see the amount of debt a potential borrower already has compared with its total assets. Generally, commercial banks prefer lending to companies with lower debt ratios, which indicate the company has a lower level of debt compared with its capital. By understanding the average debt ratio for a company in a given industry, a commercial bank can easily benchmark the debt ratio of potential borrowers.
Interest Coverage
If you remember, coverage ratios indicate a company’s ability to meet its short-term financial obligations. Among these obligations are the interest payments that banks rely on to make money. When using coverage ratios, banks compare a company’s ratio against industry standards to see whether a company has a high risk of default.
For example, when applying the interest coverage ratio, banks typically look for results that exceed 1.5. Loan applicants that fall below this threshold may be considered too risky and either (a) lose out the loan or (b) pay high interest rates to account for their high risk of default.
Debt to Equity
The debt to equity ratio indicates how much of a company’s operations are funded through debt rather than wholly owned funds. While financing debt is often key to a company’s growth, too much debt is a red flag for lenders.
When evaluating a company’s debt to equity ratio, lenders look for results in the ballpark of 1.5-2. Lenders that encounter numbers beyond this threshold may need to pass on a loan application because of the high risk involved. However, this may depend on a company’s debt to equity ratio over a span of time. That’s why the debt to equity ratio is so important to lending decisions.
For example, a lender considers a potential borrower whose debt to equity ratio is higher than 2; however, the ratio has steadily been declining over the past five years. This may indicate the company has been leveraging its debt to expand operations and is in a good position.
Current Ratio
The current ratio uses key items from the balance sheet to measure a company’s short-term liquidity. In other words, the current ratio can be used to determine a company’s ability to cover short-term debt with its current assets.
Current assets are either (a) cash or (b) assets that will be turned into cash within the year. Commercial bankers divide current assets by current liabilities (short-term debts due within the year) to draw conclusions about their clients. When clients have taken on too much debt, they sometimes need to sell off long-term, revenue-generating assets—a sign of trouble.
When calculating the current ratio, commercial bankers are looking for a ratio above 1. Clients that meet this threshold can most likely meet their short-term debt obligations without selling off long-term assets. But when short-term debts are greater than the company’s current assets, which is the case with results below 1, investment bankers may second guess the company’s standing.
A thorough assessment by investment bankers usually involves several years of data. Rather than viewing one year in isolation, investment bankers may look at five years of results to identify the trend.
For example, if a company’s current ratio trend is positive, gradually growing to 1 with little volatility, the company is faring well. Maybe they have paid their debts during the time period or experienced faster inventory turnover.
In another example, a ratio that trends negatively over five years, declining to 1, can raise red flags for bankers. Likely the company has taken on too much debt or has insufficient cash on hand.
Investment Banking
Investment banks offer a different set of services than commercial banks and usually operate as separate entities. Acting as financial advisors to corporations, and even governments, investment bankers consider various risk factors when providing services.
That’s where financial ratios come in.
Investment bankers use financial ratios to:
- Identify red flags in a company, prompting further due diligence
- Identify triggers and performance tolerance in portfolios
- Improve prospecting processes for relationship managers
- Identify how much of a prospect’s financial resources are tied up in debt
- Determine whether a prospect can maintain profitability
- Determine how much larger a prospect’s profit is than their interest payments
- Conduct credit analysis for benchmarking
- Conduct annual credit reviews
Which ratios do investment bankers use most?
- Debt to Equity
- Interest Coverage Ratio
- Return on Assets
- Net Profit to Equity
- Current Ratio
- Return on Equity (ROE)
Let's take a closer look:
Debt to Equity
Investment banks can use the debt to equity ratio to estimate how much debt a company has taken on to leverage its assets. While many companies take on debt to finance growth, it is important to calculate the company’s earnings in comparison with its debt to avoid making risky investments.
On average, the maximum acceptable debt to equity ratio is 1.5-2. While financial companies may have higher results around 10 or even 20, most other companies that exceed 2 are considered a high-risk investment.
Interest Coverage
Like commercial bankers, investment bankers want to know their clients will be able to pay interest on outstanding debt before making any agreements. Investment banks can use the interest coverage ratio to measure a company’s short-term financial health.
When using this ratio, higher results indicate a company is generating enough earnings to cover its current interest payments. That’s why a higher ratio is generally favored—but there are always exceptions.
Ultimately, the ideal ratio varies depending on the industry in question. For example, a company in the Utilities sector with an interest coverage ratio of 2 is generally deemed acceptable. However, in the Manufacturing sector, companies generally need an interest coverage ratio of at least 3 to be deemed acceptable.
Wondering why? The difference in acceptable interest coverage ratios is determined by the sector or industry’s inherent volatility. For Utilities, stable demand for services makes for low volatility. But demand is much less consistent for Manufacturers, leading to higher volatility. Case in point, interest coverage ratios should not be compared across sectors but between companies operating in the same sector or industry.
Return on Assets (ROA)
The ROA ratio is used to determine how effectively a company uses assets to generate earnings. Using this ratio, investment banks can evaluate if a company is using its assets in the most effective way possible.
Taken alone, this ratio can be misleading. That’s because it relies on the book value of assets rather than the market value.
For example, the value of a company’s assets may depreciate over time (think vehicles, machinery, etc.). In an ideal situation, this would be captured in the ROA ratio but the ratio does not account for the lower value, leading to poor results in certain cases. When a company’s assets have been overvalued, the ROA ratio does not paint an accurate picture for investment bankers.
In another example, the value of a company’s assets may increase over time (think real estate). Without adjusting the value of fixed assets to the current market value, the ROA ratio may appear higher than it actually is, misrepresenting the company’s performance.
Return on Equity (ROE)
In investment banking, the ROE ratio is used to determine companies’ sustainable growth rates and dividend growth rates. Investment banks can also use the ROE ratio to identify issues or inconsistencies within a company’s reporting.
Like the interest coverage ratio, the ROE is not usually compared across different sectors or industries. Instead, investment bankers use the ratio when comparing companies to their peers.
In a stable economy, a company’s ROE should exceed 12% to 15% to be considered good. However, results exceeding 10% may be acceptable depending on the economic landscape.
While an average or higher-than-average result is generally deemed good, an ROE ratio that vastly exceeds others in the industry may seem fishy to investment bankers. In such cases, bankers look for underlying issues with a company’s financials (jumps in profit, excess debt, negative net income).
Business Valuation
Financial ratios provide investors with more relevant information than just raw data from financial statements. They provide a good reference of relative performance to compare businesses of different sizes and capital structures. Think of financial ratios as a measuring stick for valuing comparable businesses in similar industries.
In business valuation, financial ratios can be used to benchmark current clients and to see if broader industry conditions explain a client’s financial performance. They’re also used to tailor predictions for cash flow projections in a new business. Due to the various ways in which business valuation is conducted and used, a plethora of financial ratios can be used in the practice.
Business valuation firms use financial ratios for:
- Evaluating merger and acquisition transactions
- Employee stock ownership plans
- Business and private litigation and asset distribution
- Estate planning
- Mediation and arbitration of disputes
- Bankruptcy, liquidation or reorganization of a company
Which ratios do business valuation firms use most?
- Current Assets
- Net Profit to Equity
- Receivables Turnover
- Debt to Equity
- Total Assets
Let's take a closer look:
Current Assets
Current assets may include cash, accounts receivable, stock inventory and other liquid assets that are expected to be used in business operations over a given year. As a result, understanding current assets for a given company is key in business valuation methods such as liquidation value.
Many business valuation firms are hired when companies are self-assessing or preparing for a merger or acquisition. In such cases, it is vital to understand a company’s liquidity position, which the current assets ratio can provide.
For example, suppose a business valuation firm is evaluating an acquisition opportunity for a client. A low level of current assets compared with the company’s monthly expenses will quickly raise a red flag that the company is not in an adequate liquidity position. This information will significantly inform the business valuation process.
Receivables Turnover
While many business valuations calculate a company’s ability to repay debt, the receivables turnover ratio is used to determine a company’s ability to collect on money owed by clients. In turn, this ratio provides key insight into a company’s cash flow and overall turnover rate, which can inform the company’s ability to keep up with expenses.
Business valuation firms can use this information in various ways. The receivables turnover rate is vital when considering acquisition, merger or business spin-offs. Moreover, companies can use the receivables turnover ratio internally to evaluate efficiencies.
For example, if a company hires a business valuation firm to determine internal inefficiencies, it can find its receivables turnover ratio. By comparing this ratio with its competitors and the overall industry average, the company can adjust its receivable period to remain competitive but improve efficiencies.
Net Profit to Equity
This ratio is vital in business valuation and is a popular method for calculating the profitability of an investment. Also known as “return on investment (ROI),” net profit to equity ratio is used for various purposes by business valuation firms, including liquidation proceedings, business reorganizations, stock option and incentive plans, among others.
A good net profit to equity ratio is somewhat in the eye of the beholder. By this, we mean the investor and their preferences – High risk generally means high reward, and so on. Still, understanding industry and sector averages can help business valuation firms determine where a given company or stock stands compared with its peers.
Auditing & Accounting
Auditors and accounting professionals rely on a variety of financial ratios when reviewing a company’s financials. While the exact ratios used will vary depending on the type of client they are working with, the main ratios primarily used by auditors fall into three general categories: operating, liquidity and leverage.
The type of ratio used by an auditor or accountant will likely depend on the type of industry in question. For instance, the inventory turnover ratio is crucial in auditing clients in the Retail sector but is of less importance when working with clients in the Financial sector.
Let’s take a closer look at the ratios that matter most to auditors and accountants.
Auditors and accountants use financial ratios to:
- Benchmark clients across an industry
- Familiarize oneself with base expectations for the industry before digging into a client’s financials
- Identify red flags or anomalies in financials
- Determine lines of questions
- Review in “limited assurance” audits
Which ratios do auditors and accountants use most?
- Current Ratio
- Quick Ratio
- Days’ Receivables
- Inventory Turnover
- Debt to Equity
- Return on Total Assets
- Payables Turnover Ratio
- Interest Coverage Ratio
Let's take a closer look:
Quick Ratio
Also known as the acid-test ratio, the quick ratio compares short-term assets to short-term liabilities. Similar to the current ratio, the quick ratio measures a company’s ability to pay off short-term obligations with certain assets. The ratios differ in one key way: The quick ratio only looks at liquid assets rather than all current assets.
In most cases, the quick ratio should exceed 1. However, the benchmark for a “good” quick ratio differs across industries.
For example, retail industries generally have quick ratios below 1 due to their large amount of inventory. Even with an elevated quick ratio, retailers can still be deemed healthy. Looking at industry benchmarks for quick ratios can help auditors make fair assessments.
Inventory Turnover
As noted earlier, the inventory turnover ratio calculates how many times a company has sold and replaced inventory during a given period. While this ratio isn’t relevant across all industries, it’s particularly important when auditing companies in the Manufacturing or Retail Sectors.
What do auditors glean from this ratio? Low inventory turnover often means a company is struggling, experiencing weak sales and likely has excess inventory. On the other hand, high inventory turnover generally translates to strong sales, which comes with some benefits and drawbacks. Sure, strong sales are a good thing but the potential for inventory shortages is higher.
Inventory levels vary from company to company, even within individual sectors. That’s why, unlike other financial ratios, there is no magic number for the inventory turnover ratio.
So how do auditors make their conclusions? Auditors work from industry-standard benchmarks.
Take Jewelry Stores, for example. Their niche offerings often lead to low inventory turnover. But for luxury items like jewelry, low turnover isn’t always an issue. In this case, Jewelry Stores’ high margins make up for low turnover.
In another example, Grocery Stores generally experience a high inventory turnover rate, but their margins aren’t quite as high. The low per-unit cost of their products means that Grocery Stores need higher inventory turnover to turn a profit.
Interest Coverage Ratio
The interest coverage ratio is used by auditors to determine how well a client can pay the interest on any outstanding debt and can provide key insight into a company’s health and longevity.
As mentioned earlier, interest coverage ratios can vary from industry to industry or sector to sector. That’s where industry research comes in handy. For example, a company in the Utilities sector with an interest coverage ratio of 2 is generally deemed acceptable. However, in the Manufacturing sector, companies generally need an interest coverage ratio of at least 3 to be deemed acceptable.
The thresholds for industries and sectors differ depending on the level of volatility, with Manufacturing being more volatile than Utilities in the example above. Comparing results against industry-standard thresholds can help auditors make well-informed conclusions.
Like other ratios, the interest coverage ratio works best when applied over several years. While calculating a company’s interest coverage ratio for a single year is helpful, using a time series is even better as it can help identify long-standing trends, which will illuminate a company’s standing more clearly.
Entrepreneurs
Financial ratios are highly valuable to entrepreneurs. Entrepreneurs use financial ratios for myriad reasons, from weighing the risk of entering a new business venture to evaluating the performance of a current venture.
Entrepreneurs use financial ratios to:
- Determine if broader industry conditions explain current financial performance
- Tailor predictions for cash flow projections in a new venture
- Use as a basis for economic adjustments to a company’s financial statement
- Familiarize oneself with base expectations for an industry when weighing the viability of a business
- Compare current operations with the industry average before seeking additional funding or investors
Which ratios do entrepreneurs use most?
- Tangible Debt/Tangible Net Worth
- Cash Flow Coverage
- Interest Coverage Ratio
- Current Ratio
- Inventory Turnover
- Return on Assets (ROA)
- Debt to Equity
- Days’ Inventory
- Collection Period for Accounts Receivable
The specific ratios relevant to an entrepreneur will likely depend on the industry(s) they operate in. For example, an entrepreneur that’s looking to enter a Retail industry will have more use for the days’ inventory ratio than an entrepreneur considering a service-related industry. Meanwhile, the debt ratio will likely be valuable to all entrepreneurs, regardless of their industry(s) of operation.
Let's take a closer look:
Collection Period for Accounts Receivable (Days)
Before starting up business, entrepreneurs should consider the average collection period in an industry. Companies operating in all industries need cash to stay up and running, and getting that cash quickly is ideal in any situation. But different industries have different benchmarks and have adjusted their business models accordingly.
For example, if the industry of interest experiences longer collection periods, the entrepreneur knows they will need greater cash on hand to cover costs in the interim.
Industry research that highlights the average collection period for accounts receivable can help entrepreneurs in the business planning stages as they identify areas of concern. When business owners have trouble collecting what they’re owed, turning a profit can seem impossible. In fact, even profitable companies risk going out of business if they can’t collect their payments in a timely fashion.
As business ventures get off the ground, entrepreneurs can continuously monitor their results and compare the average collection period in their own business to industry standards. If the company’s collection period is significantly longer than the industry average, it indicates the company should adopt more aggressive collection policies to shorten the time frame
Debt to Equity
As we covered earlier, the debt to equity ratio indicates how much of a company’s operations are funded through debt rather than wholly owned funds. In the same way an entrepreneur can be enticed by an industry’s high earnings, they can be turned off by high debt. That’s because high debt comes with a high level of risk.
Industries that operate with high debt are usually capital intensive (think Car & Automobile Manufacturing, Oil Drilling & Gas Extraction, etc.). Entrepreneurs that enter these industries typically know what to expect. They realize that taking on the added risk will pay off if they are able to generate more earnings in the long run.
On the other hand, sometimes the cost of debt financing can outweigh the returns. An entrepreneur getting into a risky, capital intensive industry should keep close track of their debt to equity ratio because of its impact on share values.
Current Ratio
The current ratio is valuable to entrepreneurs operating in various sectors, as it measures a company’s ability to cover its short-term debt with current assets.
As mentioned above, fixed or capital assets (long-term assets) are big investments that are expected to pay off in the long run. But when business owners are unable to cover their short-term debt with current assets, they sometimes need to sell off long-term, revenue-generating assets to make ends meet. That’s why it’s so important for entrepreneurs to track their liquidity with the current ratio.
When tracking the current ratio, the magic number is 1. Ratios above 1 suggest the company is able to meet its short-term debt obligations without selling off long-term assets. Still, the ideal current ratio can vary depending on the industry in question. For instance, Manufacturing industries generally require significant capital investment. As a result, the ideal current ratio for a traditional manufacturing industry is 2 or more.
Like other financial ratios, the current ratio is most informative when looked at over several years. Entrepreneurs can look at industry benchmarks to determine whether their current ratio stacks up to their peers’ and see how much it may change from year to year.
Procurement
Procurement professionals, also referred to as buyers, use financial ratios to calculate the risk of working with their suppliers before entering into agreements. Financial failure of key suppliers can have devastating impacts on a company’s supply chain, which is why financial analysis is so important.
While insolvency is the main concern procurement departments consider when evaluating financial ratios, there are other applications for these ratios, too.
Procurement departments use financial ratios to:
- Qualify or disqualify potential suppliers
- Gauge supplier’s capability to invest in new product development, research and development
- Present actionable data to stakeholders
- Justify switching from one supplier to another
- Assess inventory turnover and the possibility of product shortages
Which ratios do procurement departments use most?
- Return on Assets
- Net Profit to Equity
- Inventory Turnover
- Days’ Inventory
- Current Ratio
- Quick Ratio
- Debt Ratio
- Debt to Equity Ratio
- Collection Period for Accounts Receivable
Let's take a closer look:
Debt Ratio
The debt ratio measure is a good indicator of a supplier/company’s financial risk, making it relevant to procurement departments. A debt ratio of 1 indicates that a company would have to sell all its assets in order to pay all its liabilities, which may render the company insolvent. However, a company with a lower debt ratio has lower overall debt, which indicates a long-term position of solvency.
Procurement departments can use the debt ratio to qualify or disqualify potential suppliers. When a sourcing professional can see that a company is set up for long-term success, they are more assured that a constant supply of goods and/or services will be available from that company. That’s why a supplier with a favorable debt ratio is more likely to be awarded a contract than a company with high debt and higher risk of insolvency.
Inventory Turnover
The inventory turnover ratio calculates how many times a company has sold and replaced inventory during a given period. It comes in handy when evaluating companies the procurement department will contract with over the long term, stipulating regular delivery of raw materials or other goods.
A low ratio often implies weak sales or excess inventory (i.e. overstocking), thus indicating operating inefficiency. Although a high ratio may suggest strong sales, which indicates operating efficiency, a high ratio can also imply insufficient inventory (i.e. shortages), which indicates operating inefficiency.
Shortages are especially important for procurement teams to consider because unexpected delays in product delivery can halt the buyers’ operations, especially if the buyer relies on a single source for their materials and has nowhere to turn when their supplier fails to deliver.
Benchmarking Like a Pro
You’ve made it to the end. Congratulations! Now it’s time to start putting financial ratios to work.
If you’ve learned anything from this guide, it’s that some financial ratios are cut and dry while others come with a few caveats. More times than not, evaluating financial ratios means looking at sector- or industry-level benchmarks to make fair conclusions about a company.
Where do these benchmarks come from?
We’ve mentioned a few common benchmarks for specific industries or sectors in this guide, but there are tons of industries and sub-industries out there, making for lots of variation. Luckily IBISWorld has you covered with thousands of Industry Research Reports that offer the key financial ratios you need.
Don’t waste time Googling for acceptable thresholds only to turn up something overly general and entirely unhelpful. IBISWorld drills down to the industry and company level to help you see the nuances you need to make strategic decisions.
Book a free demo today to start benchmarking like a pro.
