Checking the Balance: Ratios

Now that you have a basic understanding of the items contained in the income statement (from the previous chapter) and contained in the balance sheet, it is time to compare the size or proportion of different items to each other. This comparison is known as checking the balance, or the ratios, of an organization. Ratios tell Senior managers and savvy WLP professionals where problems exist and can hint at what interventions might create the most value by bringing the items back into balance.

Current and Quick Ratios

The goal for any company is to keep its ratios of assets to liabilities above one, or, in other words, to have more assets than liabilities such that there are no restrictions in normal business activities due to a shortage of cash and no embarrassment of having to put off creditors. These proportions are often expressed as the current ratio or the quick, or liquidity, ratio.

Lenders like to see more assets than liabilities because that means that the organization can find a way to repay its loans. To derive the current ratio, current assets are divided by current liabilities.

The quick (or liquidity) ratio is an even harsher test of whether a company can pay back its loans. This ratio excludes inventory from the total amount of current assets and then divides by current liabilities. Inventory can sometimes be very difficult to sell. An example of hard-to-sell inventory is trendy fashions that suddenly go out of style.

Was ABC MediCompany in a good position to have taken on the additional long- term debt to renovate, improve processes, and expand some of its marketing efforts? Even with the new debt, ABC has enough assets to pay its obligations. To see how this works out, let ‚ s look at some financial ratios. Figure 5-5 shows five financial ratios for ABC.

The current ratio and the quick ratio demonstrate the balance between ABC ‚ s most liquid assets (current assets) and ABC ‚ s debts or obligations that must be paid the most quickly (current liabilities). With a current ratio of 3.45, ABC has nearly three and a half times the number of current assets as it does current liabilities. Even when applying a more stringent criterion, it appears that with a quick ratio of 2.71 that ABC still has nearly two and three- quarters more assets than liabilities and could pay off its current debt.

 

Figure 5-5: Sample financial ratios.

Important ‚  

Ratios are important to understand because they offer a shortcut to knowing what your Senior executives will value. Sometimes your executives will align management incentives and performance programs to improve a specific ratio. If you understand which two items are being measured against each other, you will know where to direct your WLP interventions and how to connect the value of what you bring to the table directly to the items in the ratio.

Knowing a company ‚ s current and quick ratios is only half of the story. Knowing what is reasonable and customary within a company ‚ s industry is the other half. Let ‚ s get a little more specific about the industry ABC MediCompany operates in.

If you were to go to www.bizminer.com, select ‚“Health Care, ‚½ and ask for a financial analysis profile for electromedical equipment, you would be able to find an industry financial analysis report that summarizes how other firms in this industry are doing. These profiles are not free, so keep in mind that there are other ways to find this information. This example just gives you a brief idea of what kinds of data you can find about an industry from existing financial data services.

In the year ending July 2002 for the electromedical equipment industry, the average company maintained a current ratio of slightly over three (3.2) and a quick ratio of just over one and a half (1.6). Comparatively speaking, ABC is doing as well or better than its competitors .

Because ABC seems to be in relatively good shape in its current ratio and quick ratio, would Senior executives pay as much attention to a proposal for how WLP could improve the ratio even more? If ABC were considering taking on even more debt the answer might be yes. If ABC were not considering more debt, then Senior executives may pay attention to other ratios first. Senior executives might rather want to know if they are getting enough value from the assets they already have. This leads to another ratio, return-on-assets (ROA).

 

Return-on-Assets

Return-on-assets describes how much profit a company generated for each dollar in assets. It is also an excellent indicator of asset intensity ‚ how much is required in the way of big and expensive assets to generate profit for an organization. Companies can be asset-intensive (the ROA is less than 5 percent) or asset-light (the ROA is greater than 20 percent). A railroad , for example, is asset- intensive . An advertising company is asset-light (beginnersinvest.about.com, 2003a).

The ROA is calculated by dividing net profit by total assets. It is often expressed as a percentage, thus:

As you can see in figure 5-5, ABC MediCompany has an ROA of 0.09 or 9%. The Bizminer report for electromedical equipment reveals that the last three years have been very difficult in this industry. The average net profit is negative, so the average industry ROA is negative as well. For ABC to have a positive ROA of 9 percent, it must have a very special niche or be doing something to sell more asset-light services to offset the costs of its manufacturing operations.

You ‚ ll see in a subsequent chapter on business intelligence research how a knowledge management consultant used her insights about ABC MediCompany ‚ s ROA to ask questions about how ABC was maintaining a competitive advantage and how an investment in her knowledge management services could protect or enhance this competitive advantage.

 

Return-on-Equity

Return-on-equity (ROE) is another common ratio that investors and Senior executives will watch. It is an indicator of how well the company is reinvesting its capital. For most of the 20th century, the Standard & Poor ‚ s 500 averaged ROEs of 10 to 15 percent, with ROEs moving up into the 20 percent range for part of the 1990s. The 20 percent range has not been sustained during the economic downturn of the early ‚ 00 decade (beginnersinvest.about.com, 2003b).

The ROE is calculated by dividing net profit by the amount of owner ‚ s equity and multiplying the result by 100. ABC MediCompany ‚ s ROE is 14 percent, as you can see in figure 5-5. Is this ROE good for ABC? The minimum benchmark for ROE is the percentage yield on 30-year U.S. government bonds. A source to look up rates on 30-year U.S. bonds is http://www .marketvector.com/interest-rate/30-yr-t-bond.htm. ABC ‚ s ROE should be substantially higher than what is available from what is considered the standard for risk-free investment because if it ‚ s not, ABC management would do better to just put the company ‚ s money there rather than trying to run the business (Bing, 2002). But, as the Bizminer report shows, most of ABC ‚ s industry has produced negative ROEs for the last three years. ABC is doing well in comparison to the minimum standard and to comparable companies.

 

Leverage or Debt-to-Equity Ratio

The leverage ratio, often called the debt-to-equity ratio, is the final ratio that will be covered in this book. The leverage ratio, which is often expressed as a percentage, shows how much owner ‚ s equity there is in the company versus the combination of all of the liabilities. From a lender ‚ s point of view, the smaller the number is the better. According to Drake and Dingler (2001) any number under 0.5 (50 percent) is favorable.

Figure 5-5 shows that at ABC MediCompany, the leverage ratio is 0.51 (51 percent). Even though it is doing well compared to its industry, ABC appears to have reached the limit of the debt it can hold without being considered high risk. ABC will now have to look at ways to cut costs, raise revenues , or generally make better use of its assets to fund any additional investments it would like to make in its business. As a WLP practitioner at ABC, it would be important for you to target your interventions over the next one to three years to improve the leverage ratio to keep your organization out of the high-risk category.