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Guidelines for determining a company’s financial health

Financial ratios are a useful and convenient tool for measuring a company’s performance and its financial position. Most ratios can be computed from information taken from the organization’s financial statements.

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Financial ratios are key indicators in managing any type of company and are useful for analyzing market trends, for comparing the company’s performance to that of its competitors and, in some cases, for even predicting future bankruptcy. A document form the Inter-American Investment Corporation (IIC) describes the main financial ratios used in different business management areas and by lenders for measuring the company’s performance and risk. 

  

  • Profitability ratios: offer different financial performance measures of the firm in relation to the generation of profits.

 

Gross margin: represents the percentage of the company’s total income after paying the cost of sold goods. It is computed by subtracting the sales costs from the company’s total income divided by total income.

 

Gross Margin = gross profit (sales minus sales costs, without subtracting operating expenses/net sales (total sales minus the value of rebates and returns)

 

A company with high profitability obtains a 60% margin or more.

 

  

  • Liquidity ratios: provide information on the company’s ability to comply with its financial obligations.  

 

Instant solvency ratio or acid test: measures the company’s capacity with respect to its short-term debts and/or the ability of paying debts and obligations when due, based on its short-term receivable accounts and documents.  

 

Acid test = current assets – inventories/current liabilities

 

The ratio must be between 0.5 and 1 or more to show instant solvency.

 

 

Current solvency ratio: is an indicator for the purposes of measuring the short-term liquidity of an entity. It is computed by dividing current assets by current liabilities.

 

Solvency ratio = current assets/current liabilities 

Example: 10,000 (current assets)/5,000 (current liabilities) = 2:1

 

A company enjoying good financial health should obtain a ratio around 2 to 1. An exceptionally low solvency ratio indicates that the company will find difficulties in paying its short-term debts. In turn, a high ratio suggests that the funds are not completely being used correctly within the company, and therefore it has idle money.

 

  • Asset turnover ratios: indicate how efficiently a company is using its assets. Example: volume of accounts receivable and inventory turnover.  

 

Accounts receivable turnover: this indicator measures the efficiency of a company in collecting credit sales.  

 

Accounts receivable turnover = net credit sales/accounts receivable

 

In general, a high accounts receivable turnover ratio is favorable, while a lower figure can indicate inefficiencies in pending collection of sales.

 

 

  • Financial leverage ratios: these indicators give us an idea of the company’s long-term solvency.  

 

Debt ratio: measures the percentage of external resources over the total amount of the company’s own resources. It is measured through dividing total liabilities by total assets.  

 

Debt ratio = total liabilities/total assets

 

A 3 to 1 ratio or higher is considered a figure indicating good financial health in this regard.  

 

 

Debt coverage ratio: illustrates a person or company’s capacity to cover a certain level of debt.  It is frequently used to determine the possibility of a particular borrower’s capacity to return the money requested in loan.

 

Debt coverage ratio = net operating income (difference between gross income and operating expenses, including taxes and insurance)/total debt payment

 

If the ratio of net operating income against debt payment is lower than 1, the company should expect a negative cash flow and will not be able to pay the level of debt. If the ratio is higher than 1, the company’s earnings will not suffice to absorb the debt level. In any case, at least a 1:1 ratio is desirable.

 

   

  • Standard Industrial Code (SIC): The SIC is a system that classifies companies depending on their activity. It is important for the businessman to know the Standard Industrial Code (SIC code) and to know the one that applies to his industry. When a businessman requests a loan the financial entities compare the ratio performance with that of the industry to measure the risk upon granting credit. The list of codes can be found here.
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