"Accounting is the language of business, and you have to learn it like a language… To be successful at business, you have to understand the underlying financial values of the business." –Warren Buffett
Warren Buffett is the most successful investor in the world because he knows that great companies make great investments. Identifying great companies requires an understanding of accounting and the ability to read and interpret the basic financial statements: the income statement, balance sheet and cash flow statement. Analyzing, tracking and comparing key numbers from these statements provides the clues that will help you identify great companies.
Is your company on its way to being a great company?
A financial ratio compares the relationship between two figures from your financial statements. These ratios – when interpreted correctly – tell the story of your company. They tell us how the story of your company changes over time (for better or worse) and how it compares to other companies in your industry and other industries. Different sources classify (and name) financial ratios differently. I think the best way to classify them is based on the questions they help you answer.
Question 1: How risky is your company?
An important measure of risk is your company’s ability to pay its debts on time. To do this you need cash or other assets that can be turned into cash quickly.
Quick ratio = (Cash + accounts receivable) / Current liabilities
The quick ratio measures the ability of the company to pay what it owes in the short-term with cash and assets readily convertible into cash. Higher values are better.
Current ratio = Current assets / Current liabilities
The current ratio is similar to the quick ratio, but includes all current assets like inventory. It is a less stringent measure of risk than the quick ratio. A minimum ratio of 2 is desirable.
Current liabilities to owners’ equity = Current liabilities / Owners’ equity
Current liabilities represent money lent to the company for the short-term while owners’ equity is the value of the owners’ stake in the company. This ratio indicates how much “skin in the game” the short-term lenders have relative to the owners. The larger the number, the riskier the company is. This ratio should be below 0.8.
Question 2: How profitable is your company?
Beyond how much money your company makes, profitability ratios measure the return for investors and for the assets used to make the profit.
Profit margin = Net income / Revenues
Net income represents the profit that remains after all expenses, including taxes, are deducted. When taken as a percentage of revenues or sales, it represents the profit margin. Higher values are better.
Return on assets = Net income / Total assets
Return on assets compares the profits generated to the total assets of the company. It’s a way to determine if the company is generating sufficient profits to justify the investment that has been made. For example, a company that sells $100 and has a net income of $25 would have a 25 percent profit margin ($25 / $100). That is good.
If the company, however, has $10,000 in assets, then the Return on assets is only 0.25 percent ($25 / $10,000). Clearly the company is not profitable enough since it takes a many assets to generate that profit.
Return on equity = Net profit / Equity
Equity represents the capital of the owners. It includes the money invested as well as any profits retained by the company. The company must generate sufficient returns to justify the capital that the owners are risking in the company. Otherwise it’s not worth it for them to keep their capital in the company.
Question 3: How efficient is your company?
Efficiency measures how “hard” your company has to work to generate sales make a profit and get paid.
Inventory turnover = Revenues / Inventory
This ratio measures the relationship between your sales and your inventory. If the ratio is too high, it means that you are selling out of your inventory too quickly and may be missing out on additional sales if you maintained higher inventory levels. If it’s too low then perhaps you are overestimating your demand projections, aren’t pricing your products correctly or are experiencing some other problem.
Sales to net working capital = Revenues / (Current assets – Current liabilities)
Working capital is the difference between your current assets and current liabilities. This ratio measures how efficiently the company is using its working capital to generate sales. If the ratio is too high, it could be a sign that your company lacks sufficient working capital to operate safely.
This is by no means an exhaustive list, but it certainly is a start. A great way to track these ratios over time is by using a management dashboard.
An excellent book that explains Warren Buffett’s approach to financial statement analysis is Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage. It was written by Mary Buffett and David Clark for the non-financial person.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.