Mastering Financial Management — A CFO’s PERSPECTIVE FOR CEOs, GENERAL MANAGERS, AND BUSINESS OWNERS

Article 2. Key financial metrics and how to track them

Imagine you’re at a fancy dinner party and the host brings out a magnificent cake. You want to know if there’s enough frosting to go around (who doesn’t love frosting?), so you start slicing it up into different portions. That’s kind of what financial ratios do — they take the big, complex financial statements and slice them up into bite-sized pieces to give us a better idea of how well the company is doing. Some ratios are the liquidity ratios, which tell us if the company can pay its bills on time (because no one likes a late payment fee); profitability ratios, which reveal if the company is making enough money to cover its costs and hopefully have some left over for that fancy dinner party; solvency ratios, which show if the company has enough resources to pay off its debts because no one wants to be in debt forever or go bankrupt. So, just like slicing up that delicious cake, financial ratios help us get a clearer picture of a company’s financial health.

Therefore, key financial metrics are essential for tracking a company’s financial performance and identifying areas of strength and weakness. In this article, we’ll explore some of the most important financial metrics and how to track them. Financial ratios can be grouped into several categories based on the financial information they analyze. The main groups of financial ratios include:

a) Liquidity ratios: These ratios measure a company’s ability to meet its short-term obligations. Examples include the current ratio and the quick ratio.

b) Solvency ratios: These ratios assess a company’s long-term financial viability and ability to meet its long-term obligations. Examples include the debt-to-equity ratio and the interest coverage ratio.

c) Profitability ratios: These ratios measure a company’s ability to generate profit and maximize shareholder value. Examples include the gross profit margin, operating profit margin, and return on equity.

d) Efficiency ratios: These ratios measure a company’s ability to utilize its assets to generate revenue. Examples include inventory turnover ratio and asset turnover ratio.

e) Valuation ratios: These ratios provide insights into how the market values a company’s stock. Examples include the price-to-earnings ratio and the price-to-book ratio.

f) Growth ratios: These ratios assess a company’s potential for future growth. Examples include the sales growth rate and the earnings per share growth rate.

These ratios and metrics help investors and analysts evaluate a company’s financial health and performance, identify strengths and weaknesses, and make the best and most informed investment or strategic decisions.

1. Liquidity ratios

Let’s start with this group of financial ratios that measure a company’s ability to meet its short-term obligations, typically within one year or less. These ratios are used to assess a company’s ability to pay its bills, debts, and other liabilities as they come due in the short term or under one year as this is defined in the financial world. Liquidity ratios are calculated based on one of the main financial statements, namely the Balance Sheet, and are very important for assessing a company’s financial health and overall ability to meet its obligations in a timely manner.

There are several key liquidity ratios that are commonly used to evaluate a company’s liquidity position, including:

a) Current Ratio: The current ratio is the ratio of current assets to current liabilities. It measures the company’s ability to pay its short-term obligations with its current assets. A current ratio of 2:1 is generally considered good, indicating that the company has twice as many current assets as current liabilities.

b) Quick Ratio or Acid-Test Ratio: The quick ratio is a more conservative measure of liquidity than the current ratio. It excludes inventory from current assets because inventory may take longer to convert to cash than other current assets. The quick ratio is calculated by subtracting inventories from current assets and dividing the result by current liabilities.

c) Cash Ratio: The cash ratio is the most conservative liquidity measure of liquidity. It measures the company’s ability to pay its short-term obligations with its cash and cash equivalents only. This ratio is calculated by dividing cash and cash equivalents by current liabilities.

Liquidity ratios are important because they provide insight into a company’s ability to meet its short-term obligations. However, it’s important to note that liquidity ratios alone do not provide a complete picture of a company’s financial health. Other financial ratios, such as profitability ratios and solvency ratios, should also be considered to get a more comprehensive view of a company’s financial performance.

2. Solvency ratios

Continuing with solvency ratios, you will find that these are the financial metrics that help determine a company’s long-term financial viability and its ability to meet its long-term obligations. We try to estimate whether the business is loaded up with too much debt to financial institutions and whether this is a stable construction. Such metrics help financial professionals gauge how risky a company is and how likely it is to default. These ratios measure the amount of debt a company has in relation to its assets, equity, and earnings. So, the main solvency ratios include:

a) debt-to-equity ratio, which is calculated by dividing total liabilities by total shareholder equity. This ratio indicates the degree to which a company relies on debt to finance its operations.

b) debt-to-assets ratio, which is calculated by dividing total liabilities by total assets, indicating the percentage of assets financed by debt.

c) interest coverage ratio, which, on the other hand, measures a company’s ability to pay its interest expenses with its earnings. It is calculated by taking Earnings Before Interest and Taxes (EBIT) and dividing by the interest expense. A higher ratio indicates a stronger ability to meet interest obligations. Solvency ratios are essential for investors and lenders as they provide insights into a company’s ability to generate profits and repay the debt over the long term (longer than one year as defined in the financial world).

Furthermore, more often than not, the CEO, the General Manager, or the Business Owner would quite often be faced with giving or receiving extended payment terms, associated credit insurance, and ratings at banks. All these financial organizations and service providers facilitate trade and payments, however, they maintain multifactor professional credit models, which are based on different solvency metrics to ensure how strong, viable, and sustainable a business is and how far away from bankruptcy the business is.

Modified Altman’s Z score is a popular solvency ratio model used to evaluate a company’s financial health and predict its likelihood of bankruptcy and all of the above-mentioned models bear some similarity to its work in general. It consists of five key elements or financial metrics, each of which provides insight into different aspects of a company’s solvency:

a) Working capital/total assets: This ratio measures a company’s ability to meet its short-term obligations using its current assets. A higher ratio indicates greater short-term solvency.

b) Retained earnings/total assets: This ratio reflects the amount of earnings the company has reinvested in the business relative to its total assets. A higher ratio indicates a company’s ability to withstand economic downturns and maintain its long-term solvency.

c) Earnings before interest and taxes/total assets: This ratio shows a company’s ability to generate profits from its assets without the impact of financing and tax. A higher ratio indicates a company’s strong operating performance and potential for future growth.

d) Market value of equity/book value of total liabilities: This ratio evaluates a company’s market value compared to its total liabilities. A higher ratio suggests investor confidence in the company’s ability to meet its long-term obligations.

e) Sales/total assets: This ratio measures a company’s efficiency in generating sales from its assets. A higher ratio indicates a company’s potential to generate higher profits and pay off its debt.

The formula for Altman’s Z score is Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

A = Working Capital / Total Assets

B = Retained Earnings / Total Assets

C = Earnings Before Interest and Taxes (EBIT) / Total Assets

D = Market Value of Equity (for approximation we can use book value of equity) / Total Liabilities

E = Sales / Total Assets

Note that Altman’s Z score is used to predict the likelihood of bankruptcy of a company. A Z score above 2.99 indicates a low probability of bankruptcy, while a score below 1.81 indicates a high probability of bankruptcy. Scores between 1.81 and 2.99 are considered uncertain.

Together, these five elements provide a comprehensive view of a company’s solvency, evaluating both its short-term and long-term financial health. By using these metrics, investors and analysts can make more informed decisions about a company’s potential for financial success or risk of bankruptcy. Every CFO would employ a similar calculation on file and maintain it regularly in order to drive the financial strategy of the company. The business strategy should completely include this aspect of strategic management in order to drive success. This is especially vital for high-growth companies, which tend to consume cash due to growth.

3. Profitability ratios or metrics

This group of metrics is solely derived from the other main financial statement — the Income Statement.

One of the most widely used financial metrics is the top line or the revenue/turnover generated by the business, which is the total amount of money a company generates from its sales. Revenue is a critical metric for measuring a company’s financial performance and growth over time.

Moving down the Income Statement, the next financial metric is gross profit margin, which measures the percentage of revenue that remains after deducting the cost of goods sold. This metric provides insight into a company’s profitability and efficiency in managing its costs.

Operating profit, also known as Earnings Before Interest and Taxes (EBIT), is a financial metric that measures a company’s profitability from its core operations by deducting operating expenses from operating revenues. It does not include non-operating revenue or expenses, such as interest on debt or gains or losses from the sale of assets. EBIT is often used as a measure of a company’s operating efficiency and profitability, as it shows how much profit the company is generating from its main business activities before taking into account the effects of financing and tax decisions. The EBIT could be measured also as a margin or a percent of sales/revenues.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company’s profitability that shows earnings before the impact of financing and accounting decisions. EBITDA is often used as a proxy for cash flow because it measures the cash generated by a company’s operations. However, it is not an ideal measure of cash flow because it does not take into account changes in working capital, capital expenditures, or debt service requirements. Many business valuation benchmarks exist based on a multiple of EBITDA. Banks would often look at a multiple called Debt to EBITDA and would impose restrictions, which would vary by industry. Overall banks consider 3x (three times) debt to EBITDA to be a healthy measure and most businesses should incorporate this understanding in their growth and success strategies. The EBITDA could be measured also as a margin or a percent of sales/revenues. Businesses in different industries can be benchmarked and compared or we could judge whether a business performs well or not.

Net profit margin is another essential financial metric that measures a company’s profitability after accounting for all expenses as a percent of revenues/turnover, including taxes and interest. This metric is a good indicator of a company’s overall financial health and its ability to generate profits from its operations.

Return on Assets or Return on Equity are metrics, which are based on the famous Return on investment (ROI) financial metric for evaluating investment projects, which measure the profitability of the business by calculating the return as a percentage of the total assets or the total equity employed by the company. These metrics are important for assessing the performance of investments and determining whether they are generating adequate returns for the company.

4. Efficiency ratios

Efficiency ratios are a set of financial ratios that help measure a company’s ability to effectively manage its assets and generate its cash flow. These ratios are also known as asset turnover ratios, as they provide insight into how efficiently a company is using its assets to generate sales.

There are several different types of efficiency ratios, including inventory turnover, accounts receivable turnover, and accounts payable turnover. Each ratio provides valuable information on how well a company is managing its inventory, collecting payments from customers, and paying its suppliers.

a) Inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a specific period. This ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory during a specific period, most often a year. The formula for the inventory turnover ratio is: Inventory turnover ratio = Cost of goods sold / Average inventory

The cost of goods sold is typically found on the income statement, while the average inventory can be calculated by adding the beginning and ending inventory balances and dividing the sum by two. The resulting inventory turnover ratio represents the number of times a company has sold and replaced its inventory over the course of a specific period, such as a year. A high inventory turnover ratio indicates that a company is efficiently managing its inventory levels and generating sales. On the other hand, a low ratio suggests that a company is holding too much inventory, which could tie up its capital and lead to wastage or obsolescence.

b) Accounts receivable turnover ratio measures how quickly a company is collecting payments from its customers. The accounts receivable turnover ratio is calculated by dividing the net sales by the average accounts receivable balance during a specific period, most often a year. The formula for the accounts receivable turnover ratio is:

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable where:

i) Net Sales: This is the total amount of credit sales made during the period minus any returns, allowances, or discounts.

ii) Average Accounts Receivable: This is the average balance of accounts receivable during the period, which is calculated by adding the beginning and ending balances of accounts receivable for the period and dividing by two.

The resulting ratio indicates the number of times a company collects its average accounts receivable balance during the period. A high accounts receivable turnover ratio suggests that a company is effectively managing its credit policies and collecting payments in a timely manner. Conversely, a low ratio could indicate that a company is struggling to collect payments, which could lead to cash flow problems and potential bad debt. Ideally, the CFO of a company would demand that sales are performed 100% with advance payments and there are no accounts receivable.

c) Similarly, the accounts payable turnover ratio measures how long it takes a company to pay its suppliers. The accounts payable turnover ratio measures how quickly a company pays off its suppliers and vendors. It is calculated by dividing the total purchases made on credit during a period by the average accounts payable balance during the same period.

The formula employed most often to estimate the accounts payable turnover ratio is:

Accounts Payable Turnover Ratio = Cost of Goods Sold / Average Accounts PayableA high accounts payable turnover ratio suggests that a company is paying its bills on time and managing its cash flow effectively. A low ratio could indicate that a company is struggling to meet its payment obligations, which could harm its relationships with suppliers and potentially lead to cash flow problems. Ideally, the CFO would push for a standard payment policy towards all suppliers of 60 days, 90 days, or on occasions of very high relative purchasing power up to 120 days and finance operations using supplier credit, which usually comes at a low(er) cost.

Please bear in mind that in certain situations, a CFO for simplicity may decide to use for all three ratios the net sales only in the formula. It is really the consistency of the calculation and the time series it develops as a sign of tendency.

These efficiency ratios could also be measured in days of a period as follows:

a) Days inventory outstanding (DIO) represents the average number of days it takes for a company to sell its inventory. It is derived from the inventory turnover ratio by dividing the number of days in a period by the inventory turnover ratio.

The formula for calculating DIO is:

DIO = (Number of days in the period) / (Inventory turnover ratio)

For example, if a company has an inventory turnover ratio of 8 and the period is 365 days, the DIO can be calculated as:

DIO = 365 / 8 = 45.63 days

This means that on average, it takes the company 45.63 days to sell its entire inventory. It is important to note that DIO is not an absolute measure of efficiency, as it can vary widely between industries and companies with different inventory management practices. However, it can be used to compare a company’s inventory management performance over time or against industry benchmarks.

b) Days Sales Outstanding (DSO) is a measure of the average number of days it takes for a company to collect payment from its customers after a sale is made. It is calculated by dividing the number of days in a period (most often a year) by the accounts receivable turnover ratio.

The formula for calculating DSO is:

DSO = (Number of days in the period) / (Accounts receivable turnover ratio)

For example, if a company has an accounts receivable turnover ratio of 10 and the period is 365 days, the DSO can be calculated as:

DSO = 365 / 10 = 36.5 days

c) Days payable outstanding (DPO) is a financial ratio that represents the average number of days a company takes to pay its accounts payable.

DPO = (Number of days in the period) / (Accounts payable turnover ratio)

For example, if a company has an accounts receivable turnover ratio of 6 and the period is 365 days, the DPO can be calculated as:

DPO = 365 / 6 = 60.8 days

Now we have found out that DSO (Days Sales Outstanding) represents the average number of days it takes for a company to collect its accounts receivable. DIO (Days Inventory Outstanding) represents the average number of days it takes for a company to sell its inventory. DPO (Days Payables Outstanding) represents the average number of days it takes for a company to pay its accounts payable.

So, if we employ the formula DSO + DIO — DPO, it gives us a key financial metric known as the cash conversion cycle (CCC), which represents the amount of time it takes for a company to convert its investments in inventory and accounts receivable into cash flows from operations, while also taking into account the time it takes to pay suppliers. A negative CCC indicates that a company is able to generate cash flow from its operations before having to pay its suppliers, which is generally seen as a positive sign.

Using the above figures, we would estimate that our CCC is 45.63 + 36.5–60.8 = 21.33 days it takes us to return our money.

5. Valuation ratios

Valuation ratios are financial metrics used to determine the worth of a non-public company’s ownership interests, such as shares or equity. These ratios evaluate the company’s financial performance, such as earnings or book value, and compare it to the current value of the ownership interests. Valuation ratios can provide insights into whether a company’s ownership interests are undervalued or overvalued in the market, helping potential investors and stakeholders make informed decisions. Any non-financial general manager, business leader, and business owner should regularly employ valuation analysis to determine the worth of their business and if they are performing their duties well. Most of these ratios are employed most often for public companies, which have a market value for their shares of equity, however, we will try to employ these key financial metrics in order to gain an understanding of what a business could be worth — a common question among different stakeholders and business owners.

One of the most common valuation ratios is the price-to-earnings (P/E) ratio, which compares a company’s current perception of the desired value (of one share) to its earnings (per share). A high P/E ratio indicates that investors are willing to pay a premium for the company’s stock, which may suggest that the company is expected to have strong future earnings growth.

Another valuation ratio is the price-to-book (P/B) ratio, which compares a company’s current perception of desired value to its book value per share. Book value is the value of a company’s assets minus its liabilities, and the P/B ratio can provide insights into whether a company’s equity is undervalued or overvalued relative to its assets.

Another valuation ratio is the price-to-sales (P/S) ratio, which compares a company’s valuation to its revenue per share. The whole business valuation can be determined by the Enterprise Value-to-EBITDA (EV/EBITDA) ratio, which compares a company’s enterprise value to its earnings before interest, taxes, depreciation, and amortization (EBITDA). When we achieve an estimate of the Enterprise Value and subtract the amount of interest-bearing obligations, we can determine the value of the business equity.

Valuation ratios are important tools for investors and analysts to assess a company’s value and potential for future growth. However, their interpretation always goes with other factors, such as industry trends, competition, and economic conditions, when employing these ratios in making various investment decisions.

6. Growth and performance ratios

Growth and performance ratios are important financial metrics that investors and analysts use to assess a company’s potential for growth and expansion. These ratios help measure the rate at which a company is growing overall and most importantly its revenue and earnings.

One such ratio is the revenue growth rate, which measures the percentage increase in a company’s revenue over a period of time. A high revenue growth rate indicates that a company is growing and expanding its business operations, which can be a positive sign for investors.

Another important growth ratio is the earnings growth rate, which measures the percentage increase in a company’s earnings over a period of time. A high earnings growth rate indicates that a company is profitable and generating increasing earnings, which can be a positive sign for investors.

Investors and analysts also use the price-to-earnings growth (PEG) ratio to evaluate a company’s growth potential. The PEG ratio compares a company’s price-to-earnings (P/E) ratio to its earnings growth rate. For example, a company with P/E ratio of 20x and earnings growth rate of 10% would have a PEG of 2x. If the growth would accelerate to 20%, the PEG becomes 1x. A low (below 1x) PEG ratio can indicate that a company’s stock is undervalued relative to its earnings growth potential.

In this section, I would also include the ROE ratio, which stands for Return on Equity, and the ROA, which stands for Return on Assets. These are financial metrics used to evaluate a company’s profitability and potential for growth.

ROE is calculated by dividing a company’s net income by its shareholders’ equity. It measures how efficiently a company is generating profits with the money invested by its shareholders. A higher ROE indicates that the company is using its shareholders’ equity effectively to generate profits. This can be an indicator that the company is well-managed and has a strong potential for growth.

ROA, on the other hand, is calculated by dividing a company’s net income by its total assets. It measures how efficiently a company is using its assets to generate profits. A higher ROA indicates that the company is using its assets effectively to generate profits. This can be an indicator that the company is making good use of its resources and has the potential for growth.

Both ROE and ROA are important metrics for analyzing a company’s potential for growth. They provide insights into how effectively a company is generating profits with the resources available to it. A higher ROE and ROA indicate that the company is making efficient use of its resources and has the potential to grow. However, it is important to consider these ratios in conjunction with other financial metrics and qualitative factors, such as the company’s competitive position, industry trends, and management team.

Understanding a company’s growth potential is critical for investors and analysts, as it can help them make informed decisions about buying or selling a company’s stock. By analyzing growth ratios, investors can identify companies that are well-positioned for future growth and avoid companies that may be experiencing a decline in growth. In this section, we will explore some of the key growth ratios that investors and analysts use to evaluate a company’s potential for growth and expansion.

7. Conclusion

After reading through this article on key financial metrics, the non-financial managers may find themselves feeling like they have started finally catching up to the CFO’s level of understanding. They can now confidently say, “EBITDA, liquidity ratios, solvency ratios, efficiency ratios? No problem, I got this!” Just don’t ask them to calculate it all by hand, or they may end up saying, “Actually, on second thought, let’s just go ask the CFO.” But hey, at least they now have a better understanding of what those acronyms actually mean!

Tracking these financial metrics is crucial for business owners and managers to monitor their financial performance and make informed decisions. In the next sections, we’ll further expand on how to understand financial statements, the importance of transparency, track these metrics, and interpret the results to make budgets and forecasts and in the end — informed decisions for achieving growth and success.