subject: Avoid The Business Ditch: Understanding Financial Performance Indicators [print this page] Countless executives operate with little or no understanding of their company financial performance. Sometimes they survive or thrive in spite of their lack of knowledge. Other times financial blindness leads to a wrecked company. Do not leave the money matters to the accountants. Business leaders in all functional areas can improve their chance of positive personal and business growth by establishing a basic understanding of financial performance indicators.
Running a business is like driving a high performance sports car. The person behind the wheel needs to scan and react to the dashboard instruments. Imagine you are driving your company down a beautiful country road and admiring the majestic lending trees, hypnotic marketing vistas and ethereal information technology clouds. But you are unaware that the company financial engine is overheating because you did not watch the instruments on your data dashboard. The breakdown could have been avoided by scanning, evaluating and responding to changes in the primary financial indicators.
The most important indicators on the financial dashboard are operating ratios. The ability to turn fixed assets, raw materials and inventory into cash is reflected in various indicators including the inventory turnover, sales-to-assets and accounts receivable ratios. These are top line indicators that reveal the general operating strength of your company. These ratios show how much revenue you generate relative to your assets, how quickly you convert assets into sales and how soon those sales are turned into cash.
Liquidity ratios are another important set of financial indicators. Every company needs the ability to pay bills as they become due. A company that does not have enough liquid assets to pay current liabilities will quickly find financial trouble. Suppliers will demand quicker payment and deny credit that can be company lifeblood. The current ratio indicator shows how many times the company can cover or pay the bills that are coming due within the next year. Current assets such as cash, short term investments and sometimes inventory can be quickly converted to cash for bill payment. Generally, current liabilities are those due within the next twelve months. The quick ratio only looks at assets that are cash or nearly cash and how many times that amount can cover bills that are immediately due. Both of these ratios should be greater than one-to-one or you may soon find yourself unable to pay your bills.
The next set of indicators tell us how much money your investment in company assets is returning. Generally people start or buy a business to make a profit. The return on assets indicator shows the amount of net profit on each dollar of assets. Some of those assets are purchased with equity and debt so the return on equity ratio reveals how much positive leverage the company is generating with borrowed funds. The goal is to generate a high enough return on the investment in the company to compensate for the risk and to match or beat the return of your industry competitors.
The last major category of performance indicators is leverage ratios. Debt can be a powerful tool to grow a business and create positive leverage. But debt used incorrectly can put your company into an unrecoverable skid. Stay away from credit crises. Keep a close eye on your leverage by using debt-to-equity, debt-to-capital and debt service coverage ratios. Your ability to comfortably service debt depends on the result of operations and liquidity. Closely monitor the change in your leverage ratios to make smart debt capital choices.
After you have calculated your operating, liquidity, profitability and leverage ratios the next step is to track your results across time periods and against industry competitors. Time-series analysis looks at the changes in financial indicators across similar time periods. Compare a month, quarter or fiscal year to the same period earlier. Cross-sectional analysis compares your financial indicators with industry competitors. Private companies tend to be secretive with their financial data for obvious reasons so it might be impossible to compare results. Instead, find the publicly traded company that leads your industry and evaluate their financial results for a general idea of the industry standard.
You can learn to calculate and understand basic financial statement indicators including operating, liquidity, profitability and leverage ratios. Monitor your financial engine across time periods and against competitors as you safely navigate the twists and turns of the roads in your industry.
