In order to understand a business, you must understand the ratios behind it – i.e., what makes it work.
Ratios provide insight into a business’ profitability, liquidity, efficiency and leverage ability. When you are analyzing a business’ balance sheets and income statements, it is helpful to calculate sales and operating ratios in order to identify areas that require further study.
- Profit ratios such as gross margin (gross profit divided by revenue) and EBITDA margin (earnings before interest, taxes, depreciation, and amortization divided by revenue) are the most straightforward. These ratios demonstrate the amount of income being generated from sales.
- Liquidity ratios, such as the current ratio (current assets divided by current liabilities) and quick ratio (cash plus accounts receivable divided by current liabilities), give insight into whether or not the company is able to operate efficiently, meet its obligations and turn its products and services into cash.
- Efficiency ratios such as inventory, accounts receivables, and accounts payables demonstrate how long it takes a company to sell inventory, collect receivables and settle payables.
- Borrowing and equity ratios and debt service ratios are key to understanding whether or not a business can pay off its debt over time. Ratios that are too tight may flag issues down the road. If you are analyzing a business for the intent of purchasing it, you need to look at the ratios as they are now, as well as how they will be including any debt you will undertake.
Ratios are not always that intuitive on their own. You must compare them to prior years to identify trends, as well as to industry standards to get the real picture of a business’ position in the market.
The significance of each ratio, the methods for calculating them, and industry averages are available through publications such as Dun & Bradstreet and Robert Morris Associates (RMA). Look for trends in the ratios over the past 3 to 5 years.
If you would like more information on ratio analysis or on buying a business, contact us at 204-478-7266×110.