When looking at the financial health of an organization many zero in on net income, but little do they know that this number is just the beginning. You need to go past net income and evaluate other key financial information and ratios to get the whole financial story of an organization. By evaluating the following four areas, you can start to fill in the gaps.
EBITDA
EBITDA stands for “Earnings before interest, taxes, depreciation and amortization.” By adding these four key items back to net income, you can get a more clear depiction of operating results and provide better comparability to other companies. Financing decisions and tax rates can vary significantly from Company to Company and impact net income and make comparison difficult. For example, if you are comparing the financial statements of two companies in the same industry and one is taxed as a corporation and one is taxed as a partnership, the partnership will most likely have a higher net income as the income tax is paid by the individual partners, but their EBITDA may show the corporation has better operating results.
Gross Margin Percentage
The gross margin percentage is sales minus cost of goods sold divided by sales. This shows financial statement readers the percentage of the sales price that is available to go toward all remaining costs of the company and net income. The gross margin percentage should be reviewed against historical results and can provide indications of trends. Significant changes up or down in the gross margin percentage could indicate issues and should be investigated further.
Accounts Receivable Ratios
There are several important ratios to consider when evaluating accounts receivable as it is one of the more common places to hide expenses and inflate revenue. By recording sales and receivables that have not occurred, or leaving receivables on the balance sheet that are no longer considered collectible, management can inflate earnings and make the operating results better than they are. The following are key ratios to evaluate when looking at AR:
• Accounts Receivable Aging Schedule
• Average collection period = Current AR / (Annual Sales / 365)
• AR Turnover ratio = Annual Sales / Average AR
• Days of Receivables = 365 / AR Turnover ratio
In many industries, standard terms for invoices are 30 days to pay. In this case, you would expect the majority of receivables to be outstanding for 30 days or less, the average collection period to be close to 30, the AR turnover to be near 12 and the days of receivables to be about 30. The further the ratios get from these expectations, the more investigation and understanding is needed.
Inventory Ratios
Similar to accounts receivable, inventory can also be another place on the balance sheet management can hide expenses they do not want to hit the income statement. Inventory also ties of up cash and can be a huge factor when evaluating a company’s cash flow and needs for financing. Consider looking at the following ratios:
• Inventory Turnover = Cost of Goods Sold / Average Inventory
• Days Sales of Inventory = (Average Inventory / Cost of Goods Sold) x 365
Management should aim to increase the turnover of its inventory and reduce its days of inventory on-hand. By reducing the days sales of inventory that are held, the company can free up cash flow and reduce its need for financing. If a company notices an upward trend of its days sales of inventory, this could be an indication of obsolete inventory on hand, the purchasing department over buying or other poor inventory management.
The Bottom Line
Evaluating these key ratios will help you understand the current operating results of an organization and put you down the right path to investigate any irregularities further.