Metrics for Assessing the Financial Health

It's a constant struggle for the managers from non-financial backgrounds to come to terms with various financial statements and measures and gaining insights from them. Needless to mention, I am one among that :). 

Recently I came across a small pocket size finance book released by the Harvard Business School (HBS). Still it was not easy for me, but one chapter that attracted me endlessly was the chapter about important financial metrics. I have given the same in the way I understood them. Hope it will be useful for you as well. Good thing about these metrics is almost all of these are collected from the 3 mandatory financial statements only (Balance Sheet, Income Statement and Cash Flow Statement)  

Profitability Ratios

Gross Profit Margin: This ratio tells you how profitable your goods/services are. Gross Profit includes only the direct costs like raw material and direct labour. It doesn't include any indirect cost like administrative costs or overhead business managers' cost. If you are doing a project, you need to include only the cost of the members who directly contribute to the project. It ignores the company overheads. Good Indian IT service companies are operating at 60~65% gross margin

Gross Profit = Total Revenue-Cost of Goods Sold(COGS)

Gross Profit Margin = Gross Profit/Total Revenue

Operating Margin: This ratio tell you how profitable your goods and services are after taking your operating overheads into account. This is an important metric that gives you an idea of the overheads the company is suffering.

Operating Margin = Operating Profit/Total Revenue

Net Profit Margin: This is a most widely followed metric by the industry. You can compare your net margin with your industry's net margin to compare your company with that of your competitors. This ratio tells you how profitable your goods and services are after considering the operating overheads, depreciation, interest, tax etc. (basically all the cost overheads either direct or indirect). Good Indian IT service companies are operating at 20~22% net margin

Net Profit Margin = Net Profit/Total Revenue

Return on Assets (ROA): This measure tells you how the company is best utilizing its current assets

RoA = Net Profit/Total Current Assets

Return on Equity(ROE): It tells you how the company is best utilizing the owner's or shareholder's equity investments in the company. Basically how much value the company is creating for the shareholders

RoE = Net Profit/Total Equity

Operating Ratios

Days Receivables: This metric tells the average number of days the company takes to receive the money it owed from the external entities like customers. It is assumed that a company that collects the receivables quickly will NOT have many operating capital shortages

Days Payables: This measure tells you the average number of days a company takes to pay its suppliers. It is assumed that a company that takes more days to pay will have that much operating capital for that duration

Days Inventory: It tells you how long it takes for the company to sell the finished goods inventory kept in the warehouses etc.

Liquidity Ratios 

Banker's Ratio/Current Ratio: This measure gives an indication to your lenders (like banks) whether the lender can give loans to your company with confidence. It's a very simple arithmetic, if you have more assets (properties  or collaterals), then lenders will easily give you loans because loan recovery is not a problem

Banker's Ratio = Total Current Assets/Total Current Liabilities

Quick Ratio: It's is something similar to the Banker's ratio, but discounts the assets that cannot be easily liquidated. Here the assets mainly discounted are your unsold inventory because it is assumed that the unsold inventory cannot be liquidated quickly

Quick Ratio = (Total Current Assets - Total Inventory) /Total Current Liabilities

Leverage Ratios

Here leveraging means how you are leveraging your loans to create value for the company

Interest Coverage (IC): This measure tells you how much your company makes (your operating profit) more than the interest payables.  Operating profits are called 'Earnings Before Interest and Tax (EBIT)' also

IC = Operating Profit/Interest Expenses

Debt-to-Equity Ratio (DE): This measure gives you an idea about how the company uses loans against owner's equity. I believe this ratio should be as small as possible which means you are funding your operations mostly from owner's equity and not leading the company to big debt trap

DE = Total Current Liabilities/Owner's Equity

Others

Earning Per Share (EPS): This measure gives you an indication of how much value the company has generated for the stakeholders for each unit of the shares held by them

EPS= Net Profit/Total Number of Outstanding Shares

P/E Ratio: This measure is very popular in the stock markets. It tells whether the share price of a company is high or low against the company's operating performance.

P/E = Current Price of the Share/Total EPS in the Last 12 Months