Business tips for food manufacturers – part 2: Financial ratios
Understanding your financial statements and ratios will help empower you in making decisions. It also allows you to assess whether your food manufacturing business can support new debt.
Use different ratios to calculate and assess your business’s financial situation and have a place in decision making.
In Part 2 of this article, we’ll walk through the 4 financial ratios that will benefit you most when managing your business. For more financial business tools, read Part 1 - financial statements.
With the information collected from financial statements, you can calculate financial ratios for a deeper dive into your financial situation. Ratios can also help you pinpoint opportunities and challenges.
- Use different ratios to calculate and assess your business’s financial situation and have a place in decision making. However, make year-to-year comparisons for similar timeframes, typically at the end of the fiscal year.
- Don’t use ratios in isolation. Your current ratio might look strong because your liabilities are low, but your working capital might be minimal.
1. Current Ratio
Use it to calculate liquidity – whether you can access cash when you need it or if your current liabilities can be paid, and you can meet financial obligations as they come due.
Current Ratio = Current Assets / Current Liabilities
Current assets include short-term liquid assets that you can reasonably convert to cash in a year (either sold directly or consumed in the current year). Examples include money, inputs such as ingredients and packaging materials, raw materials in storage and product inventory that will be sold and accounts receivable.
Current liabilities are expenses and payments due in a year. Examples include unpaid invoices for raw materials, credit cards, cash advances, payments due for longer-term debt and your line of credit.
The higher the current ratio, the better
Use your current ratio to compare against others in your industry. More importantly, track your current ratio over time to better understand operational changes. If your current ratio is declining, it’s a sign expenses are growing faster than revenues.
If your current ratio is good, you still might run into cash flow problems. Your cash may not appear on time during the year to match your expense obligations. It’s important to understand seasonality and contract revenue.
Use a cash flow budget to track the timing of cash inflow and outflow. Even with a strong current ratio, issues arise if you don’t plan. For example, carrying a large inventory of raw materials means spending a lot of money on inputs before any finished product is available for sale. The year’s current ratio may look good, but a cash flow budget will show if a cash crunch might be looming.
You’ve heard the statement cash is king?
Even if you have a strong balance sheet with lots of equity, you can miss opportunities or endure stressful challenges if you don’t have enough money available after paying your liabilities to meet obligations.
Being debt-averse can also create financial problems. Manufacturing is capital intensive and requires continual investment and replacement of assets that give back to your operation over the long term. The replacement schedule of assets is something every business owner should try to understand and even build in a bit of a buffer. The average life of an asset doesn't always mean that's the working life you'll get.
2. Debt-to-equity ratio
Use it to calculate solvency – the ability to assess whether you can meet your long-term financial obligations.
Debt to Equity = Total Liabilities – Postponed or subordinated debt / Total assets – (total liabilities + postponed or subordinated debt)
This ratio can indicate how the assets and business operations are financed, either through debt or equity.
Lenders use it to measure the extent to which creditors have financed your business compared to the degree your personal finances have been invested in the operation. Adjustments are made for debt owing to creditors or shareholders that have been postponed and subordinated.
Understanding what debt is right for your business’s short- and long-term goals is an important part of your financial success.
3. Gross margin
Use it to calculate profitability – the most exciting and probably most well-known measure. It shows if you’re you making money.
Gross Margin = Gross Profit / Revenue
This ratio is used to compare the percentage of gross profit to each sales dollar of revenue.
Gross profit is defined as the revenue minus Cost of Goods Sold (COGS), or the total variable expenses (material, labour, distribution costs, sales force costs, etc.).
You can report gross margin on a per-period basis (per month or year) or a per-unit basis. As a manufacturer, the higher the gross margin, the greater your company’s efficiency in turning raw materials into income.
4. Debt service coverage ratio (DSCR)
Use it to calculate debt service – your ability to make debt payments on time. It’s one of the first indicators a lender will examine when you’re looking to borrow more money.
DSCR = EBITDA – Drawings + Contributions / Interest + Current portion of long-term debt
EBITDA is a company’s earnings before interest + taxes + depreciation + amortization. This number provides a snapshot of operational efficiency.
Drawings are defined as dividends, drawings and repayment of shareholder loans or related company loans.
Contributions are advances by the shareholders or related companies.
Lenders are looking to see if your company can show you can repay debt obligations, even if your business experiences a revenue drop. It’s important to monitor this ratio if you apply for a loan in the future.
Ready to get a clear look at your company’s financial picture?
Here are four things you can do to get started:
- Collect information from your income tax returns, financial documents, accounting software and other records.
- Complete and update financial statements regularly and track this information.
- Calculate ratios regularly. Use FCC financial ratio calculators to make the process easier.
- Talk to your financial advisor, accountant or lender about using these tools for continual analysis of your business’s health.