In Summary
- Financial reports offer crucial insights into economic health, enabling management to identify strengths, manage risks with lenders, capture opportunities, and benchmark performance using various ratios for areas like liquidity, leverage, growth, and profitability.
- Essential financial ratios include the current ratio for assessing short-term debt payment capacity, operating cash flow for measuring cash coverage of current liabilities, the debt ratio for determining the level of debt financing, and the interest coverage ratio for evaluating the ability to meet interest expenses.
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Many Denver businesses rely on accurate and timely financial reports to provide important information about economic vitality and inform decision-making. The information contained within these reports can be used in various ways to identify strengths, uncover weaknesses, help prevent adverse relationships with lenders, capture opportunities, and even benchmark performance. Using various financial ratios, management can assess the company’s liquidity, leverage, growth, margins, profitability, and rates of return. Calculated using information from the balance sheet, income and cash flow statements, management can benchmark performance both internally and externally. These ratios are divided into five main categories, including liquidity, leverage, efficiency, profitability, and market value ratios. Given the many ratios available, it is essential to focus on the ones that provide the most valuable information. To help clients, prospects, and others, Hanson & Co has summarized the key details below.
Essential Financial Ratios
- Current Ratio – Also known as the working capital ratio, it is used to assess a company’s ability to pay off debts. It compares current assets to liabilities to determine whether management effectively balances assets, financing, and liabilities. It is calculated by dividing current assets into current liabilities. Examples of current assets can include cash and cash equivalents, accounts receivable, and inventory. For current liabilities, this may include deferred revenue, short-term debt, and accounts payable. If the current ratio is low, it means the business will have a harder time paying debts than those with a higher score.
- Operating Cash Flow – This measures the times a company can pay off current liabilities with existing cash flow. It differs from the current ratio because it measures a company’s ability to pay debt with cash, rather than assets. It is calculated by dividing cash from operations by current liabilities. A high number (greater than one) indicates the business generated more money than is needed to pay current debts. Conversely, if it is less than one it indicates the opposite.
- Debt Ratio – Also known as the debt-to-asset ratio, it is used to determine the amount of debt used to fund operations. It is calculated by dividing the company’s funded debt by total assets. Examples of funded debt include credit provided by lenders, such as bonds, term loans, lines of credit, or subordinated debt. A ratio of 1 (or 100%) reflects an unsustainable amount of debt financing to run operations. It is important to note this ratio is best used to compare companies within the same industry, as capital structures may vary between sectors.
- Interest Coverage Ratio – This ratio measures a company’s ability to meet required interest expense payments related to outstanding debt promptly. The more debt carried the greater the amount of interest must be paid to maintain it. It is calculated by dividing Earnings before interest and taxes (EBIT) by interest expense. A score of 1.5 or lower means the company is unlikely to meet interest obligations.
- Industry-Specific Ratios—Many industries, such as construction, real estate, and manufacturing, have more specific ratios applicable to companies’ financial statements in those spaces. Contact Hanson & Co. CPAs to learn more about them.