Key Financial Ratios That Will Improve Your Manufacturing Business
Financial ratios in the manufacturing industry serve as important navigational tools that help management evaluate the economic health and company trajectory. They provide an understanding of various aspects of a company’s operations, such as liquidity, efficiency, profitability and solvency. These ratios not only shape operational choices but can also give insight into potential strengths and weaknesses. Below are a few key ratios that can help gauge how well your business is performing.
Inventory Turnover Ratio
The inventory turnover ratio measures how many times a company has sold and replaced its inventory during a specific time period. Manufacturers can use this ratio to make better decisions on pricing, purchasing and timing of production. A higher inventory turnover ratio indicates efficient inventory management and sales. With a high inventory turnover ratio, a company should focus on production efficiency to ensure inventory levels meet demand. Whereas a lower number may put a company at risk for inventory obsolescence. Companies with a low inventory turnover ratio may need to reevaluate their production needs and sales targets.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Return on Net Assets
Return on net assets is an indicator of a company’s ability to generate profits from its total assets. Since manufacturing companies primarily utilize fixed assets such as inventory and equipment to produce revenue, monitoring this ratio is essential. The higher this ratio, the more efficient the company is at managing its assets and generating profit from them. This ratio will differ based on the company’s size, so it is best to compare industry averages against companies of similar gross revenue amounts.
Return on Net Assets = Net Income / (Fixed Assets + Net Working Capital)
Net Working Capital = Current Assets – Current Liabilities
Overhead Ratio
An overhead ratio measures the operating costs of doing business compared to the company’s net income. This ratio helps a company evaluate its overhead costs compared to the income the company generates. Companies want to keep their overhead low while maintaining the highest quality or competitiveness of their goods and services. When overhead costs are high relative to income, profit margins become thinner which can lead to losses or reduced quality in production. Overhead costs directly affect a company’s bottom line, so it is important to regularly review and budget to identify any potential issues.
Overhead Ratio = Operating Expenses / (Operating Income + Taxable Net Interest Income)
Debt-To-Equity Ratio
The debt-to-equity ratio is used to assess a company’s financial leverage. This ratio represents the proportion of debt-to-equity financing, which indicates its level of risk and reliance on borrowing funds. A low debt-to-equity ratio implies a lower financial risk, greater stability and potential for sustainable growth.
Debt-To-Equity Ratio = Total Debt / Total Equity
Interest Coverage Ratio
The interest coverage ratio is a measure of how easily a company can pay the interest on its outstanding debt. This ratio can be used to determine a company’s risk level relative to its current debt. Monitoring the interest coverage ratios over time can be a good indicator of the company’s current financial position and trajectory. For instance, if you look at a company’s interest coverage ratio every quarter over a five-year period, it can let investors know whether the ratio is improving, declining or remaining the same. This provides a good assessment of the company’s short-term financial health.
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
Return on Capital Employed
Return on Capital Employed (ROCE) is a financial ratio that assesses a company’s profitability and capital efficiency. It evaluates a company’s ability to cover its debts and create profits for shareholders. A higher ratio tends to indicate that a company is profitable. A ROCE of at least 20% is usually a good sign that the company is in a good financial position.
Return on Capital Employed = Earnings Before Interest and Taxes (EBIT) / (Total Assets – Current Liabilities)
Conclusion
It’s crucial that companies in the manufacturing industry utilize financial ratios to assess their performance. These ratios can provide valuable insights into the company’s operations and help management make precise decisions.
To learn more about the ratios discussed in this article or other ratios that could benefit your business, please contact me, and we can help you evaluate your company’s performance.
Contributing author: Robert C. Reeves, CPA, CFE, is an audit partner with over eight years of experience providing audit, review, compilation and consulting services to a variety of clients with a focus on the manufacturing, construction and architectural and engineering industries. Bob also specializes in providing audits of employee benefit plans, working with clients to help identify and resolve accounting issues, as well as discovering, investigating and resolving fraud cases. For more information on this topic, you may contact Bob at rreeves@dmcpas.com or (518) 836-5661.