Financial Benchmarking, Part 1
Originally published: 04.01.09 by Ruth King
Basic ratios can help you view your liquidity, inventory and receivables, giving you a big picture look at your company’s financial health.
Knowing that your business is headed in the right direction is a comforting thought. Knowing that your business is headed in the wrong direction before a crisis hits is critical to business survival. Financial benchmarking provides you the assurance that your business is going well, or the clues to when it isn’t so that you can take action.
There are two ways to look at financial benchmarking. Both should be used as complements to one another. Short-term benchmarking looks at “the numbers” on a monthly basis. Long-term benchmarking looks at the financial trends in your business.
You can make quick changes that will affect your short-term numbers. Long-term changes require systemic changes and usually cannot be accomplished in a month. These changes are analogous to turning around an ocean liner. It can’t be done quickly. When you benchmark you will learn a lot about your business.
Assuming that you have accurate financial statements, these numbers give you the ability to make good, although sometimes painful, financial decisions. Calculating these benchmarks takes at most 15 minutes each month. There is no excuse NOT to do it!
This month I’ll show you how to calculate the short-term benchmarks, next month we’ll look at long-term benchmarks. Putting these calculations into practice will ensure that your business is heading in the right direction.
Short-term benchmarks are financial ratios. I’ve developed 10 operating ratios that you need to calculate every month. These are not the same ratios that the bank asks to see. For example, the bank often asks for return on equity. From an operational standpoint, you don’t need to see return on equity each month. It’s much more important to look at the percentage compensation (which the bank doesn’t ask for) to ensure that all of your labor is productive.
Here are the 10 ratios that should be calculated each month: The current ratio is a measure of liquidity, or, in other words, how easily the company can pay its bills. You calculate this ratio by using figures from the balance sheet. The ratio is: Current Assets / Current Liabilities
For safety, this ratio should be 1.8 or greater. The higher the ratio the better.
The acid test is also a measure of liquidity. You calculate this ratio by using figures from the balance sheet. It is calculated: Current Assets - Inventory / Current Liabilities
For safety, this ratio should be 0.9 or better. Look at the relationship between the current ratio and the acid test. If the ratio is greater than 2.0 (for example if your current ratio is 3 and your acid test is 1) then you have too much money tied up in inventory.
The accounts receivable to accounts payable ratio is a measure of liquidity. You calculate this ratio by looking at the balance sheet. It is calculated by: Trade Accounts Receivable / Trade Accounts Payable If 50% or more of your sales are COD, then use trade receivables plus cash divided by accounts payable to determine this ratio. The ratio should be 2 or higher.
This financial ratio is a measure of capitalization of the company. It is calculated: Total Liabilities / Equity This ratio should be as low as possible. However, for most contracting companies it is around 2 to 3. It should definitely not be negative!
The long-term debt to equity ratio is also a measure of capitalization. You calculate this ratio by looking at the balance sheet. It is calculated: Long-Term Liabilities / Total Equity
This ratio should be between zero and 1. Percentage compensation This ratio measures the productivity of your employees. It is calculated: Total Payroll Expenses / Sales
Your company’s total compensation as a percentage of total sales should not exceed 20% if you perform mainly new construction work. If your company does mainly service and replacement it should be under 35%.
Inventory turns measure how efficiently the company uses its inventory. The turns are calculated on annual costs. Calculate this ratio by using both the income statement and the balance sheet. It is calculated: Annualized Cost of Goods Sold / Inventory
Inventory turns should be greater than 8. This financial ratio measures how long an average piece of inventory stays in the shop before it is used. You calculate this ratio from the inventory turn number. It is calculated: 365 /Inventory turns
The result should be under 45 days. This figure measures how efficiently the company keeps track of its receivables. The turns are calculated on annualized sales. Calculate this ratio by using both the income statement and the balance sheet. It is calculated: Annualized Sales /Accounts receivable
This figure should be 8 or greater. The receivable days ratio measures how efficiently the company collects its receivables. The days are calculated from the receivable turns figure. It is calculated: 365 / Receivable turns
This figure should be less than 45 days. Each month calculate these ratios and make sure they are going in the right direction. If not, fix the minor issues you see before they become major crises!
Articles by Ruth King
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