Measuring a Company’s Stability and Success

As discussed in the 1/1/2010 Blog called The 10 Key Financial Reports Every Company Should Use, all companies need to monitor their key performance indicators or kpis.   There are thousands of kpis depending on your industry, departmental area and task.  Management should determine the kpis that are the most important and make sure policies and procedures are in place to maximize results.  Comparing your company’s results to the baseline average industry kpis will allow you to identify your company’s strengths and weaknesses.  By monitoring your company’s kpis over a period of time, management can determine problem areas.

The following kpis are a good starting point regardless of your industry.  The kpis are segregated into four categories: Liquidity, Safety, Profitability and Efficiency.

Liquidity

Liquidity is defined as whether a company can pay its debts as they become due.  The standard 2 ratios used to determine a company’s liquidity are the Quick Ratio and the Current Ratio.  Please note that the ratios are only as accurate as the underlying data used.  For example, if the Accounts Receivable is overstated due to uncollectible receivables being included, than the ratio will be overstated and not an accurate measure of the company’s liquidity.

Quick Ratio is based on assets that can be easily liquidated.  Therefore, inventory is not included.  The general rule is 1:1.

Quick Ratio =     (Cash + Accounts Receivable + Other Easily Liquidated Assets) / Current Liabilities

Current Ratio proves whether the company can pay its current liabilities with current assets.

Current Ratio =         Total Current Assets / Total Current Liabilities

Safety

Safety is defined as whether a company has increased exposure due to debt.  The standard 3 ratios used to determine a company’s safety are the following: EBIT/Interest, Debt to Equity Ratio, and the Cash Flow to Current Maturity of Long-Term Debt.

EBIT/Interest Ratio defines whether the company can meet its interest payments and the company can take on more debt.  The higher the ratio the better it can meet its interest payments and take on more debt.

EBIT/Interest=          Earnings Before Interest & Taxes / Interest Expense

The higher the Debt to Equity Ratio the greater the risk to a current and future creditor of default.  However, if the ratio is too low your company is acting too conservatively.

Debt to Equity =               Total Liabilities / Total Equity

The Cash Flow to Current Maturity of Long-Term Debt ratio indicates whether the company can pay its principal debt payment over the next 12 months.

Cash Flow to Current Maturity of Long-Term Debt =       (Net Profit + Non Cash Expenses (i.e. Depreciation, Amortization)) / Current Portion of Long-Term Debt

Profitability

These profitability ratios measure the return of a company’s resources.  Positive trends indicate the company’s success in making it more profitable.  There are 4 standard ratios that should be used to determine a company’s profitability.

The Gross Profit Margin measures the company’s inventory control, pricing and production efficiency.

Gross Margin =                 Gross Profit / Total Sales

The Net Profit Margin measures the company’s operating expenses and therefore is the company generating enough sales volume to cover minimum fixed costs.

Net Profit Margin =        Net Profit / Total Sales

Return of Assets measures the company’s efficiency on generating returns on its assets.

Return on Assets =          Net Profit Before Taxes / Total Assets

Return on Equity or Return on Investment (ROI) measures a company’s return on invested capital.  Use this ratio to compare the investment in the company against other possible investment opportunities.  There is a direct correlation between risk and ROI.  The greater the risk the higher the return.

Return on Equity=           Net Profit Before Taxes / Net Worth

Efficiency

Efficiency measures how well a company effectively employs its assets.  The ratios below are standard efficiency measures.  Based on your specific industry, there will be other kpis that will need to be added to allow your company to effectively manage operations.

Accounts Receivable Turnover measures how fast the company is collecting its receivables.  Therefore, the higher the turnover, the faster the company is collecting its receivables and thereby the more cash the company has on hand.

Accounts Receivable Turnover =      Total Net Sales / Accounts Receivable

Days in Accounts Receivable indicates how many days it takes for the company to collect all accounts receivable.  The goal is to have fewer days, which indicates that the company is collecting quicker on its accounts.

Days in Accounts Receivable =          365 days / Accounts Receivable Turnover

Accounts Payable Turnover measures how fast the company is paying its creditors.  The higher the number could indicate that the company is managing its creditors and thereby holding on to its money longer or on the contrary the company is having difficulty paying its creditors due to cash liquidity issues.  Understanding the reason for the higher turnover is critical to determining if there is a major problem that requires alternative resolutions.

Accounts Payable Turnover=              Cost of Goods Sold / Accounts Payable

Days in Accounts Payable indicates how many days it takes for the company to pay all accounts payable.  Make sure your company takes advantage of vendor discounts.

Days in Accounts Payable=                  365 days / Accounts Payable Turnover

Inventory Turnover indicates how many times a company sells its inventory in one accounting period.  This is an important measure to understand whether improvement is required to correct obsolete and/or under/over stocking inventory issues.  A positive trend showing faster turnover results in improved cash flow and stronger inventory controls.

Inventory Turnover =                             Cost of Goods Sold / Inventory

Days in Inventory indicates the average length of days it takes to turnover a company’s inventory

Days in Inventory =                                 365 days / Inventory Turnover

Sales to Total Assets measures the company’s efficiency on generating sales on each dollar of assets.

Sales to Total Assets =                           Total Sales / Total Assets

Debt Coverage Ratio indicates a company’s ability to satisfy its debt obligations and its capacity to take on additional debt.

Debt Coverage =              (Net Profit + Any Non-Cash Expenses) / Principal on Debt