Top 20 Destroyers of Business Value # 10 – Not Understanding Financial Ratios and Relative Performance

Posted on October 3, 2012 · Posted in Blog

One requirement of all accredited business valuations is a thorough review of the subject company’s financial ratios and their relative comparison to industry benchmarks. Financial ratios tell a lot about a company,   its performance and are key tools in determining value.

Last week, we took a trip to South Bend to watch the Fighting Irish play the Michigan Wolverines (Go Irish!) and went to a wedding in the Detroit area.  There was a big buzz about Miguel Cabrera of the Detroit Tigers and his pursuit of the Triple Crown which was last won in 1967 by Carl Yastrzemski.    Cabrera is currently leading the league in Home Runs, RBI’s and Batting Average.  Knowing just those statistics, what do you think that says about his value as a baseball player?

I think you could safely deduct that he would be extremely valuable when compared to his peers. Financial Ratios are the statistics of business and are used by valuation analysts and investors to help determine the value of a business.

Financial Ratios help gauge a company’s performance in many different areas including; financial solvency, profitability, efficiency, return on investment and even employee performance.  Valuation analysts and investors compare a wide range of ratios to industry norms that are available through various service providers. Companies that are performing better than average typically garner higher valuations and more interest by investors.

In addition to their use in valuation analysis, business owners can use them as “Dashboards” to monitor company performance.  For example, the Quick Ratio is used to evaluate the potential of cash flow issues.  The Quick Ratio is Current Assets – Inventory divided by Current Liabilities.  For most companies this is Accounts Receivable + Cash divided by Current Liabilities.  While the average varies by industry, typically a ratio of 2:1 and higher is considered above average.  As this number gets closer to 1:1 and below, the probability of cash flow issues increases and the value of the business would be lower.

While there are literally dozens of ratios that can be evaluated, a handful can give a solid insight to the relative performance of a company especially when compared to other businesses in the same industry.

Here is a link to a website that lists and explains many common ratios:

http://www.investopedia.com/university/ratios/#axzz28AiTxvz3

Business owners should work with their financial advisors to understand financial ratios and how they can be used to help manage the business and increase value.  While there is no Triple Crown for businesses, there are still above and below average performers.  Take the time to understand how your business stacks up!

Are you destroying value by not understanding your Financial Ratios?

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