A manufacturing company requires efficient use of inventory, equipment, and personnel to develop its products. A company uses the following financial ratios to evaluate its business. These ratios can also be used to gauge the appropriateness of operations and to determine how well the manufacturing process is going.
These financial ratios are equally useful to an investor wishing to gain a deeper understanding of a manufacturing company.
Key Takeaways
- Manufacturing companies need to use their inventory, equipment, and personnel efficiently to develop their products.
- Companies use several financial ratios to determine how efficient they really are.
- Investors can use this information to determine just how worthy companies are for investment.
- Financial ratios for manufacturing companies include how well they turn over inventory, their maintenance costs to expenses, and their revenue per employee.
Inventory Turnover
The inventory turnover ratio measures the effectiveness of a company’s manufacturing process. This ratio shows how many times a company sells and replaces its inventory over a specific period of time. It is measured by dividing the cost of goods sold by the average balance in inventory.
Companies can use this ratio to make better decisions about theirpricing, manufacturing, marketing, and new inventory orders.
An investor should maintain a watchful eye for a turnover ratio that is high, as a low calculation is an indicator that a manufacturing company is handling too much inventory. This places the manufacturing entity at a greater risk for inventory obsolescence or theft of company property.
Maintenance Costs to Total Expenses
A manufacturing company may utilize equipment or machinery during the production process of its goods. A critical measurement of the sustainability of long-term operations is comparing repair and maintenance costs to total expenses.
A low proportion of repair costs signals one of two things. First, a company has in place durable fixed assets that don't require much ongoing maintenance. Second, a company may elect to simply replace equipment with newer, more reliable heavy machinery. In either case, an investor gains insight into management's long-term strategic planning to implement available technology.
Revenue Per Employee Ratio
Dividing the total revenue of a manufacturing company by the number of employees generates the revenue earned per employee. An investor uses the calculation to determine the technological efficiency of an entity.
Employee turnover affects a company's revenue per employee.
For example, two manufacturing companies each earned $10 million in revenue. However, one manufacturing company has 50 employees, while the other has 20. Assuming they produce similar goods, the company with 50 employees may be operating inefficiently.
Alternatively, the company with 20 employees is theoretically employing more efficient technologies with greater capabilities.
To an investor, this metric is important, as the company with 20 employees is better financially leveraged in the long term.
Total Manufacturing Costs Per Unit Minus Materials
A manufacturing company incurs numerous expenses while developing and manufacturing a product. Although the direct materials of the product are easily traceable, the numerous other factors and charges that go into a good may not be as easy to identify.
Therefore, this financial metric divides the total manufacturing costs, not including direct materials, by the number of units produced. An investor can utilize this figure by determining how much overhead is required to produce a good and how efficient a company’s process is compared to other entities.
Manufacturing Costs to Total Expenses
A manufacturing company incurs expenses while producing a product as well as indirect costs needed to operate the business. From an investor’s standpoint, it is more desirable to see a majority of costs directly tied to production as opposed to other expenses, including supervisor salaries or building rent.
Manufacturing costs to total expenses is a financial metric that measures this proportion. A higher calculated result indicates more expenses are attributable to costs directly needed to manufacture the product.
Return on Net Assets
A manufacturing company utilizes its fixed assets—primarily inventory and equipment—to produce revenue. For this reason, an important financial measurement is a return on net assets.
By dividing the net income from a manufacturing plant by the net assets of the division, a manufacturing company can measure how successful parts of its business are in utilizing its assets to develop a profit for the company.
An investor should use this ratio to determine the most efficient manufacturing companies.
Unit Contribution Margin Ratio
The contribution margin ratio is calculated by taking the difference between total revenue and total variable costs and dividing this figure by total revenue.
For example, products sold for $1,000 with $300 of variable costs have a contribution margin ratio of 70% (($1,000 - $300) / $1,000). The ratio measures what percentage of revenue is attributed to covering fixed costs.
An investor can use this ratio to determine the security of a manufacturing company. A manufacturing company with a high contribution margin ratio has an easier time covering fixed costs and is less risky as an investment.
What Are Common Profitability Ratios?
Profitability ratios are financial metrics used to assess the profitability of a company. Common profitability ratios include gross profit, operating profit, net profit, EBITDA, return on assets, and return on equity.
What Is the Current Ratio?
The current ratio is a financial metric that measures a company's liquidity. It is calculated as current assets / current liabilities. The ratio determines a company's ability to pay its short-term obligations within a year. A current ratio equal to the industry average or higher is considered to have good liquidity and can pay its obligations. A current ratio below the industry average may indicate a company that may not be able to meet its obligations and one that could be in distress and default.
What Is the Operating Cash Flow Ratio?
The operating cash flow ratio determines how many times a company can pay off its current liabilities with the current generated cash. The more times it can, the better financial position it is in; however, too high a number may mean it is not using its assets effectively. It is calculated as operating cash flow / current liabilities.
The Bottom Line
Financial ratios are key tools in analyzing a company to determine whether a company would be a good investment. There are lots of financial ratios, some that work better given a specific industry, due to that industry's unique profile.
For example, running an airline would be more capital-intensive than running a startup, due to an airline needing to purchase planes and jet fuel. The manufacturing industry is no different, having its own special characteristics. Utilizing the ratios above should help you better understand manufacturing companies.
