Alliance Advisory Group Blog

A recent Business Week article, http://bit.ly/duusrO, discusses how large cap companies have restructured their balances sheets in light of the economic slowdown, namely deleveraging.

Whether this was voluntary or forced upon them it was obviously the right thing to do in light of falling revenues and squeezed margins.

We have been leading many of our clients through the same sort of exercise but in a much more strategic and focused fashion.

Engaging in a process to actually measure a firm’s financial health we help them understand where they are, where they should or need to be and, more importantly, the specific steps they need to take to get there.

The raw numbers on your balance sheet, income statement and cash flow statement are just that. They only have value when tracked and measured against some standard of performance (either internally oriented or externally generated). The secret to effective financial management lies in knowing which ratios to track and what they tell you about the state of your business.

Unlike the profit and loss (income) statement, which is a historical recording that never changes, the balance sheet is a living, breathing document that changes on a daily basis. Three important balance sheet ratios to track are:

* Current ratio (Current assets/current liabilities)
* Quick ratio ([Cash + receivables]/current liabilities)
* Debt-to-equity ratio (Net worth/total liabilities)

The P&L statement focuses on revenues, expenses and net income (or loss) over a defined period of time. It measures the company’s ability to turn sales/revenues into profits, a key ingredient for long-term success. Key P&L ratio’s to track would include:

* Gross income (Revenues – cost of goods sold)
* Gross margin (Net sales – cost of goods sold)
* Net operating profit (Gross margin – SG&A expenses)
* Net profit (Net operating profit + income) – (other expenses + taxes)

Gross margin the most important ratio on the P&L. If you lose the gross margin battle you can do a lot of other things right and still go out of business.

Key operating ratios combine information from the balance sheet and income statement to provide a more sophisticated look at what is happening with the business. These include:

* Gross profit ratio (Gross profit/sales)
* Pretax profit ratio (Pretax profit/sales)
* Sales-to-assets ratio (Total assets/sales)
* Return on assets ratio (Pretax profits/total assets)
* Return on equity ratio (Pretax profit/equity)
* Inventory turnover ratio (Cost of goods sold/inventory)
* Days in inventory ratio (Inventory turnover/365 days)
* Accounts receivable turnover ratio (Sales/accounts receivable)
* Collection period ratio (Accounts receivable turnover/365 days)
* Accounts payable turnover ratio (Cost of goods sold/accounts payable)
* Payable period ratio (Accounts payable turnover/365 days)

You should track and measure your performance ratio’s at least monthly and compare them to internally generated standards of performance (i.e. budget) or against an external source of data (i.e. peer comparisons for your industry)