How profitable should a company be?

Klaus Bartram

Success can be planned:

A company can only be successful in the long term if the most important key figures for profitable corporate management are known. Many entrepreneurs - not just start-ups - make the mistake of acting out of the gut and do not deal with the key figures of their company, or only inadequately. Start-up companies fail more and more often because they did not understand how to keep an eye on the development of their company key figures. These are very important because the company key figures are used to evaluate the company. In a time of growing competitive pressure, business management tools are an important element for efficient work. The aim of a company analysis is to obtain decision-relevant information about the current and future economic situation by processing and compressing information into key figures. Company key figures are becoming more and more practical for management. They are the basics and practical knowledge for every company. Only those who are sufficiently informed about their own company can identify risks early on and take advantage of opportunities in good time. This gives him competitive advantages through the targeted use of existing information.
I would like to introduce you to the ten most important company figures here:

  • Asset coverage
  • Cash flow
  • Equity ratio
  • Return on equity
  • Receivables turnover
  • Liquidity level
  • Material cost ratio
  • Personnel expense ratio
  • Return on sales
  • Leverage

However, it is not very helpful to regularly check the company figures. Because that alone allows little conclusions to be drawn about the success of a company. The key is to compare your own figures with the industry figures. This is the only way to find out where the weak points may be. Comparative values ​​can be obtained from the chambers of industry and commerce or the associations.


Asset coverage
The asset coverage makes a statement about the stability of corporate financing. The asset coverage makes a - at least rough - statement about the stability of corporate financing. A distinction is made between asset coverage level I and asset coverage level II:

    Equity x 100
    --------------------- = Plant coverage rate I.
    Capital assets

The coverage ratio I shows what percentage of the fixed assets are financed with equity. A coverage ratio I of 60 percent means, for example, that one euro of fixed assets is offset by 60 cents of equity and therefore parts of the fixed assets (40 percent) have to be financed with outside capital.

    Equity + long-term debt x 100
    -------------------------------------------------- ---- = Plant coverage level II
    Capital assets

The coverage ratio II shows what percentage of the fixed assets are financed over the long term. A coverage ratio II of 90 percent means, for example, that only 90 percent of the fixed assets are financed in the long term and the remaining 10 percent in the short term. Since the fixed assets are tied up in the long term, they should generally also be financed over the long term. Conversely, the current assets would not be sufficient to service all of the short-term borrowed capital. The coverage ratio II should therefore be at least 100 percent. Values ​​above 100 percent indicate that operating current assets with a long-term character (such as minimum stocks) are also covered.


Cash flow
The cash flow shows how much money is available for future investments, profit distribution, repayment of debts or to increase liquidity. It measures the financial strength of a company. The cash flow expresses the surplus (operating income minus operating expenses) in a period (usually a financial year) that has been generated from the company's own resources. It therefore provides information about the liquidity of a company. The cash flow shows which funds are available for investments, debt repayment and profit distribution. For lenders, cash flow is an important criterion for assessing creditworthiness. The data for the cash flow are calculated from the annual financial statements. The annual result is increased by the costs that have arisen due to security bookings and tax tactics and therefore do not lead directly to expenses (e.g. depreciation, special provisions, etc.)

General formula:

    Cash flow = annual surplus + depreciation + increase in long-term provisions

Cash flow expresses the ability of a company to reinvest its own funds, repay debts and pay dividends without having to rely on funds from third parties. The freely available cash flow (FCF) forms the basis for many valuation models, as it measures the financial resources that are available to the company for discretionary use after the obligations have been settled. The higher the FCF, the healthier the company, as more funds are available for growth, dividend payments, etc.


Equity ratio
The equity ratio indicates how high the share of equity in total capital is. Equity is the most important yardstick for evaluating a company. Particularly when negotiating loans, the relationship between one's own capital and total capital is measured. That means what percentage of your own financial commitment to external third parties (banks, suppliers, other donors). The equity ratio (EKQ) indicates the ratio of total capital and equity and thus allows conclusions to be drawn about the solvency of a company. This key figure thus expresses the extent to which the business owner (s) participate in the financing of the business by contributing equity.

    Equity x 100
    --------------------- = equity ratio
    Total assets

Basically:

  • the higher the equity ratio, the more creditworthy a company is
  • the more equity that is brought in, the higher the equity ratio increases
  • the more equity is brought in, the more the owner or owners are involved in the entrepreneurial risk

Return on equity
This key figure indicates how much interest is paid on the equity contributed to the company. So it answers the question of whether bringing in the equity is profitable. A company's profitability can be measured in a number of ways, such as profitability on equity. The company's key figure return on equity, also known as return on equity, enables a comparison with the return offered by other forms of investment. Ultimately, it is about evaluating the profitability of a company in order, for example, to be able to make decisions in comparison with alternatives. The return on equity should - in the medium term - be well above the market interest rate, because otherwise the equity is better invested elsewhere.

    Net income (profit) x 100
    --------------------------------------- = Return on Equity
    Equity

The profit is used as the balance sheet profit plus the addition of provisions and taxes on income, earnings and assets. The return on equity is therefore a key figure that shows how much the company has earned on equity. The higher the return, the better. The return on equity is also an indicator of the growth rate at which the company can grow on its own, i.e. without additional financing.


Receivables turnover
This company key figure shows how long it takes for defaulting payers to settle a company's outstanding invoices. Receivables are understood to be the company's claims to consideration (usually in cash) for deliveries and services provided by the company or the claim to the redemption of an obligation entered into. Claims can exist against own shareholders, customers, suppliers or other business partners. Receivables are shown on the assets side of the balance sheet. Corporations must - depending on the size class - show their claims according to the Commercial Code (§ 265 ff HGB) in a special way in the balance sheet. Receivables can belong to both fixed assets and current assets. Claims are also classified according to security and duration. The key figure receivables turnover shows how long it takes for defaulting payers to settle a company's invoices.

    Open claims x 360
    ------------------------------ = Claim envelope
    sales

Payment behavior in Germany is generally considered to be poor. One more reason to decisively counteract the turnover of receivables right from the start. You should always keep an eye on outstanding claims and issue regular reminders. You shouldn't wait too long with payment orders. One of the most common reasons small and medium-sized businesses fail is poor payment practices. Attract your customers with discounts so that they pay on time. If a major demand fails, it not only seriously reduces the company's own success, it can also be a threat to the very existence of the company.


Liquidity level
If a company is able to pay its debts, it is liquid. Liquidity is a key figure that expresses a company's willingness to pay. For the company to be able to act, it is necessary to have sufficient liquid funds available so that the company's solvency remains guaranteed. Liquidity describes the company's availability of liquid funds. The task of liquidity planning is to maintain solvency. A company must be able to pay wages and salaries, liabilities to suppliers, loan repayments, interest, etc. at all times. Companies usually have different types of assets. However, while cash and bank balances can be used immediately, the liquidation period and the liquidation proceeds must be taken into account when liquidating assets such as machines or real estate. These assets can only be converted into liquid funds with a corresponding delay. Liquidity describes the company's availability of liquid funds. If a company is able to pay its debts, it is liquid. Liquidity is a key figure that expresses a company's willingness to pay. The degree of liquidity indicates the extent to which a company is able to settle short-term liabilities without affecting its fixed assets.

    Working capital x 100
    ---------------------------------- = Degree of liquidity
    short term liabilities

The liquidity of a company can be measured in several stages and is divided into different degrees:

  • Liquidity level I - the cash liquidity, which is based only on the ratio of the cash holdings to the overdraft facilities used
  • Liquidity level II - which includes short-term receivables and liabilities, and
  • Liquidity level III - the ratio between current assets and short-term borrowed capital

For the payment of short-term liabilities, the liquidity level I is decisive, which shows how much cash and cash equivalents are actually available to the company. Liquidity level II describes the financial resources that are in current assets, but that can be made liquid relatively quickly (e.g. customer receivables and securities holdings). The liquidity level II is an important parameter, especially for bank negotiations, as it allows an insight into the assets and sales situation of the company in addition to the cash on hand and liquid cash. Liquidity level III includes all current assets and all liabilities.

1st degree liquidity
This includes cash and bank balances that are available on a daily basis. Since these funds are available at short notice, they are particularly important for liquidity.

    Available means of payment (bank, cash register, bill of exchange) x 100
    -------------------------------------------------- ---------------- = 1st degree liquidity
    short term liabilities

2nd degree liquidity

    Available cash and short-term receivables x 100
    -------------------------------------------------- ---------------------- = 2nd degree liquidity
    short term liabilities

3rd degree liquidity

    Total working capital x 100
    ---------------------------------------- = 3rd degree liquidity
    short term liabilities

Illiquidity
If the company is no longer solvent, this can lead to the termination of business activities or at least to major disadvantages.

Excess liquidity
If more liquid funds are available than are necessary at the relevant point in time, this has the disadvantage that profitability drops, since the otherwise possible income cannot be achieved. It is therefore essential to avoid illiquidity through effective liquidity planning and to use free funds sensibly.


Material cost ratio
The cost of materials ratio is a key figure that shows how much raw material was required in relation to sales. The cost of materials includes all costs that are required to manufacture the company's products or to generate the company's sales. Only the costs of the raw materials that are actually incurred for the products sold in the financial year are recorded. The remainder is shown on the balance sheet under inventories. The material cost quota is thus a key figure that shows how much raw material was required in relation to sales. The cost of materials quota indicates whether raw materials were wasted in production (for example, whether there is a high degree of rejects) or whether raw materials were purchased too expensively. A high cost of materials quota should be the reason to talk to the supplier about more favorable conditions or to optimize the production processes.

    Material costs x 100
    -------------------------- = material cost ratio
    sales

If the cost of materials increases in relation to sales, either more material was used (often in retail, when more goods have to be written off), or the raw materials have become more expensive without the price increase being passed on to customers. Or the same sales could no longer be achieved due to competition and the resulting price pressure.


Personnel expense ratio
The personnel cost ratio shows the share of personnel costs in the company's overall performance. The personnel expenditure quota indicates the share of personnel expenditure in the overall operational performance. The personnel expenses result from the sum of wages, salaries and social expenses. The quota enables conclusions to be drawn about the degree of rationalization of a company as well as the work intensity. This company key figure shows, for example when comparing several financial years, the change in personnel cost intensity in a company. The development should be comprehensible through plausible explanations (such as changes in the average workforce, wage increases, social plans).

    Personnel expenses x 100
    --------------------------- = personnel expense ratio
    sales

This value is heavily influenced, among other things, by outsourcing and flexible working hours.


Return on sales
This metric shows how profitable a company is. It expresses what percentage of the turnover remains as profit for the company. Turnover is the sum of all normal operating income of a company that it generates with its deliveries and services. Sales are reported in the company's income statement (sales). The return on sales is also called the return on sales. It results from the relationship between the profit achieved and the sales revenue. This company metric is regularly used to compare similar companies. This operational key figure shows the percentage of sales that the company received as profit for investment purposes and profit distribution. The return on sales is instructive if you want to compare companies that operate in similar business fields. Basically:

  • the higher the number, the more profitable a company is
  • if the value falls, measures must be taken to counter the downward trend


  • Net income (profit) x 100
    --------------------------------------- = return on sales
    sales

The return on sales indicates as a percentage how much profit was achieved with one euro of sales revenue. A return on sales of ten percent means that a profit of ten cents was generated for every euro spent. The return on sales (in percent) is therefore a measure of how profitable a company is.The higher the percentage, the more profitable the company is. It is calculated as the return on sales before tax or after tax. Before taxes, it offers a better comparison of companies from different countries or different legal forms. After tax, it gives a better indication of how high the return actually is. In the case of company acquisitions, a return on sales before interest and taxes is often used because it can be assumed that the financing structure will fundamentally change and the interest payments are therefore not relevant.

  • Calculation before taxes: earnings before taxes / sales
  • Calculation after taxes: annual surplus / sales

Leverage
The degree of indebtedness indicates how much debt capital is accounted for in a unit of equity as a percentage. The level of indebtedness is a key figure that is relevant in two forms when analyzing the balance sheet. On the one hand as a static level of indebtedness (debt capital: total capital) to analyze the capital structure based on the balance sheet, and on the other hand as a dynamic level of indebtedness (effective debt: cash flow), which expresses the time span (years) required to get out of the cash flow to repay the effective debts (receivables minus liabilities). The degree of indebtedness of a company is calculated from the ratio of debt to equity. In principle, the higher the level of indebtedness a company has, the more dependent the company is on external creditors. This company metric shows how long it takes for the loans taken out for the company to be repaid. Of course, this value only retains its meaningfulness as long as future investments are not financed by outside capital. The degree of indebtedness is calculated by dividing the debt capital (liabilities) by the equity.

    Borrowed capital x 100
    ---------------------- = leverage
    Equity

A variant of the key figure is the dynamic degree of wastage. To do this, the liabilities are divided by the cash flow.

    Liabilities - cash and cash equivalents
    ------------------------------------- = leverage
    Cash flow

Increasing debt over time is not fundamentally negative. For example, if a company raises capital to finance projects with a return above the interest rate on borrowed capital, this is ultimately to be assessed positively. In finance, this is understood to be the so-called leverage effect. However, if the company's profitability erodes with increasing debt, this can point to a later insolvency of the company. As a result, the indebtedness and equity ratio indicators must never be viewed in isolation, but should always be analyzed in conjunction with the company's earnings position. In principle, it can be stated that a higher earnings risk should be taken into account through a higher equity ratio, since a higher equity ratio increases the company's financial stability. As a general rule of thumb, the debt level should be below 100 percent if possible.


Further company figures
In addition to the company key figures already described, there are other operational key figures from the balance sheet values, the income statement, as well as ratios:

Balance sheet values

  • Land and buildings as a percentage of total assets
  • Other tangible assets as a percentage of total assets
  • Inventories as a percentage of current assets
  • Cash on hand as a percentage of current assets
  • Receivables as a percentage of current assets
  • Securities as a percentage of current assets
  • Participations as a percentage of current assets
  • Equity as a percentage of total assets
  • Short-term borrowed capital from credit institutions as a percentage of total assets
  • Short-term borrowed capital from prepayments received as a percentage of total assets
  • Short-term debt from deliveries and services as a percentage of total assets
  • Long-term debt as a percentage of total assets Provisions as a percentage of total assets
  • Sales as a percentage of total assets

Paying the income statement

  • Income
  • Other income
  • Material costs as a percentage of sales
  • Personnel expenses as a percentage of sales
  • Depreciation on property, plant and equipment as a percentage of sales
  • Other depreciation as a percentage of sales
  • Interest expenses as a percentage of sales
  • Taxes as a percentage of sales
  • Other expenses as a percentage of sales
  • Annual surplus

Ratios

  • Inventories as a percentage of sales
  • Short-term receivables as a percentage of sales
  • Own funds as a percentage of property, plant and equipment
  • Short-term available capital as a percentage of property, plant and equipment
  • Long-term available capital as a percentage of fixed assets
  • Annual result and interest expense in the amount of the balance sheet total