Financial and Nonfinancial Ratios as Indicators of Business Health

Financial ratios are another important tool that can be used to analyze an organization's performance. A financial ratio compares two values; the result is a useful measure that can be compared to benchmarks of financial performance.

One argument against excessive use of financial measures is that they can overemphasize the importance of short-term results. Viewing financial results as trends can help lessen this effect.

In addition, financial measures must always be used within the context of a specific industry. Profit margins, for example, are very different in financial services than they are in manufacturing consumer goods. Part of the discussion with colleagues from finance should include understanding industry metrics and how the organization compares with similar enterprises.

Exhibit lists some common financial ratios and describes their significance and how they are calculated. We have already mentioned some of these ratios in our discussion of the income statement.

                                                    Exhibit: Sample Financial Ratios

Description	Formula
Current ratio Liquidity ratio that indicates level of working capital. Creditors prefer a higher current ratio.	Current assets Current liabilities
Debt-to-asset ratio Leverage ratio reflecting the amount of exposure to risk from debt that an organization has assumed. A number greater than 1 indicates that an organization has more debt than assets.	Total liabilities Total assets
Debt to equity ratio Leverage ratio reflecting how an organization is funding its growth. This varies by industry and strategy type.	Total debt Shareholders' equity
Accounts receivable turnover Activity ratio that measures the efficiency of debt collection. A higher ratio is preferable, but a ratio that is too high could indicate excessively tight credit policies that could hurt sales.	Net credit sales Average accounts receivable
Gross margin Profitability ratio showing the percentage of total sales revenue after incurring the direct costs of producing goods and services sold. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.	Total sales - Cost of goods sold (COGS)                       Total sales
Earnings before interest, taxes, depreciation, and amortization (EBITDA) margin Profitability ratio often used as measure of management performance.	Earnings before interest, tax, and depreciation                            Total sales
Profit margin Profitability after all expenses have been deducted, expressed as a percentage of revenue (sales).	Total sales - Total costs          Total sales
Return on investment (ROI) Profitability ratio for a specific investment, such as a capital expense project. It is usually used to compare the economic costs and gains of options. A good investment generally has an ROI above 1. Analyses showing negative ROIs may then proceed to consider factors whose economic impact is more difficult to measure (for example, improved employee motivation).	Gain from investment - Cost of investment                    Cost of investment
Earnings per share (EPS) Profitability ratio used by equity holders as a standard expression of earnings.	Net income Number of outstanding shares
Price to earnings (P/E) Market value ratio that indicates market confidence in the organization's ability to maintain or increase earnings.	Stock price per share Earnings per share

 

Nonfinancial Performance Measures

Nonfinancial measures examine changes in areas that are not measured in terms of currency but whose effects can be monetized to show their financial effect. Such measures might include:

·        Share of market, which may signify competitive strength.

·        Achievements in social responsibility.

·        Efficiency (or use of most current and efficient technology and processes).

·        Activity ratios, which measure the efficiency with which resources are used to generate profit (examples include number of inventory turns in a period, average age of inventory, average collection and payment period, and asset turnover).

·        Employee retention and job satisfaction ratings.

·        Employee engagement.

·        Market position, which might include the following factors:

Reputation among investors, consumers, governments, and political groups.

Level of brand awareness among consumers. Recognizable employer brand (useful in recruiting and hiring). Reputation for quality, customer relations, and innovation.

Conducting a SWOT (strengths, weaknesses, opportunities, threats) analysis can help identify which of these measures (or others not listed) are most relevant to the organization's strategy or which areas could benefit from more resources in order to achieve certain goals and objectives or exploit identified opportunities.

Such an analysis could have repercussions for HR strategy. For example, if it is decided that the organization's brand is not sufficiently well-known to justify an expansion, a decision might be made to hire more brand ambassadors. This will require adjustments to hiring practices and perhaps also changes to business travel policies and budgets. Similarly, if a decision is made to expand the organization's market or processes abroad, then HR will have to incorporate new legal and regulatory considerations into its workforce management plans.