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Financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something.However,a careful combination of ratios can provide a very helpful insight into a comapany's performce.
Most important Ratios that can be used are :
1.Liquidity
2.Leverage
3.Rate of Return ratios.
These ratios are compared against Industry norms,agreegate economy and a company's past performance.
NOTE: Evidence suggests that, as early as five years before a firm fails, one may be able to detect trouble from the value of these financial ratios.
Except for those ratios used to evaluate the performance by listed companies, if you company is small and not listed, all the remaining are useful.
Ratios are as dynamic as the realities of a company, small or large, it does not matter. They have therefore a meaning if analyzed on a time frame basis (3-4 fiscal years) against each other, to spot trends and variations.
They also need to be bench marked in order to gauge the performance of your company against sector or industry peers, this is a tricky aspect, you might find that the peers are under performing as a whole sector, the fact that you do slightly better doesn't grant a pass .Always strive for standing out from the pack.
Benchmarking might not be as simple as it sounds when we are talking about small firms or under performing peers group.
I have a couple of tricks that I have used:
- Benchmarking: peers' comparison might not be that simple for small, non listed companies or sector under performance; however in this case I use benchmark of based on investors and lending institutions parameters. Talk to your local bank and ask them what they would like to see if they would have to lend you money; or look up at the return investment firms make on investments in the same sector or industry, it will give you some useful benchmarks to gauge your performance and appeal. Benchmarking helps you set management objectives and tangible targets over time; it is very appealing to an investor when you talk in terms of short-medium-long term financial objectives it give him the perception that you have things under control.Another approach is to work out a WACC figure and look at it as target return against lower risk alternatives of investment.
- Ratios are postulates, the same as the data they are derived from (financial statements); do not be afraid of playing around a bit with them and see what happens. For instance one exercise I do relates to ratios derived from or composed of data recorded on "accrued" basis. These are good but what I also like to see is the variation of the ratio based on "actual cash in and cash out" or " cash flow based ratio analysis", the time related financial aspect of the ratio. For companies with long production-sales cycle, you will see that there will be some roller coasting in the values but you will have a much more meaningful number to play with.
- Do the analysis on projected financial statements as well it is very helpful for setting targets and see how they vary if you play around a bit with some "what if" thinking.
My two cents.
PS: A brief explanation of "playing around" with ratios just in case the concept is not of immediate grasp. What I mean is the equivalent of a dynamic sensitivity analysis. Input your financial statement data on an Excel spreadsheet and in the following pages the formulas for the ratios. Once you get the the results just start playing on a "what if" basis. What if the sales go down by so much, what if I get a better interest rate on a loan from X bank, what if I invest in a more efficient machine to Y job? And so on and see how the ratios become alive sort of speak.
I used to do that in presentations to top management, they go nuts, looking at the immediate results of operational variable changes on financial ratios.
