Blueprint's Top 5 Financial Ratios
There is so much that can be learned from looking at the Financial accounts of the businesses that you deal with. Here are to Top 5 things I would tend to look at first.
1. Core Margin: From the Income Statement take EBIT (Earnings before interest and tax) as a percentage of turnover, and compare this year on year. This will be a strong indication of what is happening to their core margin, is it thinning or enriching. Remember in any single year if Turnover is increasing by a larger percentage than EBIT, then core margin is thinning, and if EBIT is growing faster than turnover then margins are enriching.
2. Debtor Days: The average number of days that they are taking to get paid by their customers. This is calculated by taking Trade Receivables (from the Current Assets in the Balance sheet) divided by Turnover multiplied by 365. It's nice to use as a benchmark to compare companies, how does this compare with your debtor days?
3. Creditor Days: The average number of days it takes them to pay their suppliers. This is calculated by taking Trade Payables (from the Current Liabilities of the Balance sheet) and dividing it by Cost of Sales from the Income Statement and multiplying this by 365. This is also a useful benchmark, if you are supplying this company, are they paying you quicker or more slowly than the average?
4. GMROI (Gross Margin Return on Inventory) This is a strong measurement indicating the amount of gross profit that a business will make in a year in return from the money that they have invested in inventory) It is a fantastic ratio for comparing product efficiency in returning cash from initial investment. A GMROI can also be calculated to compare promotional activity too, where the period taken is not a year but the length of time the promotion runs for. The standard ratio is calculated by taking the Gross profit for a year (or for a promotional cycle) divided by the cost of product at any single point in time. If the ratio comes results in a number of say 3.44, this means that for every pound invested in inventory an annual (or promotion period) gross profit of £3.44 is achieved. Super for comparing competitive product commercial efficiency.
5. Return on Capital Employed (ROCE), this is the key measurement of how efficiently a business returns cash as a percentage of the amount of capital that is tied up in the business. It is calculated as the Profit before Tax (taken from the income statement) divided by the Capital Employed (Taken from the Balance Sheet by calculating Fixed Assets+Current Assets-Current Liabilities.) The ratio is always shown as a % and is one of the key drivers to value companies and drive share price performance.
All of this is really useful during negotiations or general business analysis. If any of this confused you, please let me know and I will work it through with you, alternatively please sign up to Blueprints Applied Finance course.
Happy number crunching!