Financial ratios – Look beyond the numbers

By in Accounting and Finance, Opinion

“If you Can’t Measure it, You Can’t Improve it” – Peter Drucker.

 Financial ratios have been used to measure and improve business performance since the days of early share markets.  However, this century’s technological revolution allows CFOs to keep track of more metrics than ever before.

With an array of digital dashboards now available to measure everything from inventory turnover days to payment error rates, the modern CFO could be forgiven for feeling overwhelmed by the sheer volume of data available.  However, rather than seeing this data explosion as a burden, one ought to view it as an opportunity.

While once management reporting was 80 percent gathering information and 20 percent analysing it, automation allows CFOs to flip this ratio on its head and focus more on understanding the data and providing valuable insights to senior management.

Understand the Metrics that Matter

A close eye on the numbers can keep you and your business ahead of risks and help quickly identify opportunities.  However there is a risk of losing focus if you try to measure everything.  So how do you identify the key metrics that matter?

Common Ratios

 

Financial ratios should assist you and your management team to narrow their focus to the key value drivers of the business.  The most effective are those that are tied to your business objectives and accurately reflect the performance you’d like to measure.

As a guide, we would expect your typical monthly movement analysis to be accompanied by around five key ratios with analysis.

Set clearly defined goals

In isolation, even the best metrics falter, they need to be tied to a specific performance goal, whether that’s a specific targeted number, a percentage of internal improvement, or a benchmark that’s tied to the local competition

On a periodic basis, it’s useful to complete a high level benchmarking exercise against other organisations in your industry. This can provide you with some insight, or at least understanding, on areas of opportunity or weakness.

Dive Deeper

Financial ratios alone will not give you the full picture.  All financial results are a by-product of strategic or operational decisions.  Neglecting the operational inputs behind your ratios will not assist you in improving performance.

Any relevant or unexpected movements need to be analysed and reported on.  Simply stating that gross margin has reduced by a certain percentage is not sufficient.  Try to substantiate the movement with non-financial data where possible. Cross check your findings to verify that they are logical and ensure no other matters need to be considered as a result.

As an example, when you are completing your gross margin analysis you may discover from talking with the operations manager that a particular machine was not operating at full capacity due to maintenance issues. This has certainly contributed to the decline in gross margin and can explain the movement.

You might then look more closely at the hours of downtime verified to maintenance records and also report on the cost incurred to repair the equipment.  Depending on the timing of the repair, you may forecast anticipated loss of revenue and the costs of repair that will be coming through in future months.

Trend Analysis

Any management reporting should also include a robust trend analysis.

For example, analysing revenue data over the course of a number of years may lead to the determination that sales are consistently down in one region at a particular time of year.

The figures might prompt you to meet with the local managing director to better understand if there are particular cultural reasons (such as religious festivals that minimise consumer spending) or demographic trends (such as a higher proportion of families leaving the area during school holidays) that are impacting sales.

Understanding the reasons behind the movements will assist your management team in making an informed decision, including options to address the issue such as re-distributing inventory or temporarily changing opening hours..

Aside from the typical monthly analysis of results to budget, trends in financial data can be useful when setting strategy. Historical financial data can demonstrate trends that may need to be addressed. For example, have margins changed on specific goods or services and why. To answer these types of questions, you need to be able to look at the ratios over time and consider the broader industry and economic conditions.

Have you been impacted by digital disruption, innovation, competition or new markets? Are there opportunities arising from this? As the CFO, you may not be charged with setting the strategy, however you can contribute significantly by providing robust analysis on longer-term trends that may demonstrate key factors to consider.

Ratios are only as good as the analysis supporting them and the quality and consistency of information used to generate them.

William Buck assists management teams to identify the most relevant financial ratios for their business and works with finance teams to uncover the truth behind the numbers. With a broad client base in the middle market, we can also assist with benchmarking across a number of industries.

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