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Financial Ratios: Key Indicators of Business Health

Financial ratios are the tools used by a company’s stakeholders and management to understand its growth levels, financial health, risk appetite, and overall performance.

These ratios act as guidance when it comes to making investment-related and financial decisions since they give an insight into the current conditions and future opportunities.

Financial ratios are necessary for assessing how much profit and revenue a company has generated by using business expenses and assets.

Here in this guide, we have gathered information on some of the key financial ratios. These ratios can help you determine the financial health of your business.

What are financial ratios?

Financial ratios are the best quantitative metric used to measure a company’s financial condition. This is a process that brings out the correct status of the business and then makes forecasts related to possibilities of growth and expansion.

Financial ratios are also referred to as financial ratios or accounting ratios. These ratios are useful for stockholders’ understanding and management decision-making. These are quite easy to interpret and calculate. As a result, these have become essential tools for company evaluation.

financial ratios

Investors, management, and analysts can utilise analysis of financial ratios for measuring efficiency, solvency, profitability, debt concentration, and financial position. So, a financial ratio can help stakeholders make informed decisions.

Financial ratios usually come from a company’s balance sheet, cash flow statement, and income statement.

Financial ratios inside a business

Due to the following internal reasons, financial planning and analysis professionals use financial ratios:

  • To calculate profit margin
  • To assess the efficiency of a company and how the costs are allocated
  • To measure return on capital investments
  • To identify trends in profitability
  • To calculate how much debt is used to finance the operation
  • To measure the ability of the company to settle debt and liabilities
  • To assess inventory management systems
  • To identify operating bottlenecks
  • To manage working capital and short-term funding needs

How external stakeholders and analysts use financial ratios

Financial ratios can be used by external stakeholders:

  • Figure out whether to finance a company in the form of debt
  • Carry out competitor analysis
  • Figure out whether to buy shares in the company or provide equity financing
  • Measure the market value of the company
  • Perform market analysis
  • Calculate tax liabilities
  • Calculate return on shareholders’ equity

Finacial ratio

Key Financial ratios for every business

There are five key financial ratios that every business should track. These are:

  1. Liquidity ratios
  2. Profitability ratios
  3. Efficiency ratios
  4. Leverage ratios
  5. Market value ratios

Let us take a look at each kind of financial ratio individually:

Liquidity ratios

A company uses a liquidity ratio when it comes to measuring working capital performance, i.e., the money available to meet the current and short-term obligations. Every company requires liquidity to pay its bills.

Liquidity ratios evaluate the capacity of a company to meet short-term obligations. These ratios are a key indicator of the financial health. Solvency is different from liquidity as it measures the ability to pay all the debts of the company.

The liquidity ratio offers a key warning system to a company, which lets the business know when it is running low on available funds. Such ratios calculate the amount of liquidity, i.e., cash and easily converted assets, to cover your debts and also provide a broad overview of the financial health.

Liquidity ratios

The following are the ways to calculate the liquidity ratio:

Current ratio

The current ratio calculates how the current assets of a business are used to settle the current liabilities. The current assets can be cash, accounts receivable, cash equivalents, and inventories, and your liabilities could be accounts payable.

This ratio is the simplest of them all to calculate and interpret. All you have to do is find the current assets, along with current liabilities, of the company, using the balance sheet and then divide the assets by the liabilities. You will receive the current ratio.

Current ratio = Current Assets / Current Liabilities

Quick ratio (acid-test ratio)

Quick ratio or acid-test ratio measures a business’s liquid assets.

You can use the current ratio for the evaluation of the short-term solvency or liquidity position. However, it is good to know the immediate status or the instant debt-paying ability, for which you would need a quick ratio, the stricter test of the two.

The acid-test ratio only considers specific current assets. This ratio considers more liquid assets like cash, marketable securities, and accounts receivable. Current assets like prepaid expenses and inventory are left out since these are less liquid.

Thus, the quick ratio or acid-test ratio is more of a true test as it can tell a lot about a company’s ability to cover short-term obligations.

Quick ratio = (Current Assets – Prepaid expenses – Inventories) / Current Liabilities

Cash ratio

If a company is going through some financial trouble, the cash ratio is useful since it takes into account the company’s most liquid assets, i.e., cash and marketable securities. These assets are the most readily available when a company has to pay short-term obligations.

Cash ratio = Cash & Cash equivalent / Current Liabilities

Profitability ratios

Profitability ratios represent how well the company uses its assets to generate profit, along with value, for its shareholders. These ratios are used by investors and analysts to measure and evaluate the company’s ability to generate income (or profit) relative to revenue during a specific time.

A higher value or ratio is usually preferred by most companies since it represents that the business is doing well by generating revenues and cash flow. These ratios can be even more insightful when they are compared to the results of similar companies or even to the previous performance in the previous periods.

Profitability ratios

Some of the most common profitability ratios are as follows:

Gross profit

Gross profit is the money left from the total revenue of a business after the cost of goods sold is deducted.

Gross profit margin ratio

The gross profit margin ratio compares the gross profit of a business to the total revenue to show how much profit has been made by the business after paying the cost of goods sold.

The gross profit margin ratio represents the percentage margin between what it costs you in the cost of sales and what you receive for your service or product.

The gross profit margin will let you know if your sales are enough to cover the costs of goods sold. Along with this, it lets you compare your business’s performance with other businesses or with your historical data. It is a good measurement of how efficient the business is when it comes to converting products or services into revenue.

Gross profit margin (%) = (Gross profit / Total revenue) x 100

The value will depend on the sector or industry.

Net Profit Margin ratio

This ratio is essential to compare your business’s net profit to the total revenue with the purpose of determining operating efficiency.

The net profit margin is a crucial indicator of a business’s health. You can assess the following through this ratio:

  • If the operating costs, as well as overhead costs of your business, are being managed.
  • If enough profit is being generated from your business’s sales

Net profit margin (%) = (Net profit / Total revenue) x 100

The value will depend upon industry and other factors. {5% (low), 10% (average), 20% (high)}

Return on assets ratio

The return on assets ratio is used to evaluate how well a business uses its assets to make a profit. The ROA ratio is helpful in assessing the financial strength of a business along with its efficiency in utilising all the available resources.

The return on assets ratio provides a valuable business benchmark compared to other businesses in the industry or sector.

Return on asset ratio (%) = (Net profit / Total assets) x 100

5% is considered good, whereas 20% or higher is an excellent figure.

Return on equity ratio

The return on equity ratio assesses whether all the effort being put into the company is able to return an appropriate return on the equity generated.

An increasing and sustainable return on equity (ROE) over time represents that the business is doing well when it comes to generating value for you. On the other hand, a declining ROE may mean that you are making poor decisions regarding reinvesting capital in unproductive assets.

Return on equity (%) = Net profit / Owner’s equity

A high ROE (return on equity) indicates that the business is able to generate cash internally.

Earning to sales ratio

Earning to sales ratio measures a business’s profits against the sales to ensure that the amount being spent is not more than what is being made.

This ratio measures how well you can contain your expenses.

Earnings to sales ratio (%) = (Net profit / Total sales) x 100

You can set a goal for yourself to achieve a certain percentage.

Material-to-sales ratio

The material-to-sales ratio measures the amount of sales (in dollars) that is consumed by the cost of direct materials.

Material to sales ratio (%) = (Cost of direct materials / sales) x 100

Efficiency ratios

Efficiency ratios are helpful in analysing a business’s short-term ability to turn its current assets into income. In other terms, efficiency ratios, or activity ratios, can show how effectively a business uses working capital to generate sales.

Efficiency ratios

There are different types of efficiency ratios. Let us discuss each efficiency ratio in detail:

Asset turnover ratio

It is widely known that to generate sales, a company uses its assets. But how many sales (in dollars) can be generated by one in assets?

The asset turnover ratio evaluates how much net sales are generated from average assets. A high asset turnover ratio represents that the company is efficient when it comes to producing sales from assets. A low ratio, on the other hand, means the exact opposite.

Asset turnover ratio = net sales / average total assets

Inventory turnover ratio

This financial ratio is a metric used for the comparison of goods sold to the average value of inventory within an accounting period.

In simpler terms, the inventory turnover ratio represents how many times a business can sell out its inventory in its entirety within a financial year. The inventory turnover ratio is used by a business to determine how the inventory is being sold.

When the ratio is low, it can state that either the sales strategies of the company are weak or the market demand is decreasing.

Inventory turnover ratio = Cost of goods sold / average value of inventory

Accounts Payable turnover ratio

This financial ratio calculates how fast a business pays its creditors and suppliers.

The money a company needs to pay to its suppliers for buying goods and services in order to keep the business running is called accounts payable.

A higher value of the accounts payable turnover ratio may show that the company’s invoice management is efficient, due to which it is able to pay the supplier or vendor on time or before the deadline.

Accounts Payable turnover ratio = Net credit purchases / Average accounts payable

Days sales in inventory ratio

Days sales in inventory ratio measure how long the business holds its inventories before converting them to finished products or selling to customers.

Days sales in inventory or the average age of inventory ratio helps you estimate how long the current stock of your business’s inventory will last.

Having a low value of this ratio means that a company sells its products rapidly. However, if the value of this ratio falls too low, it may indicate that there are supply chain problems along with an inability to fulfil orders.

Days sales in inventory ratio = (Value of inventory / Cost of goods sold) x number of days in the period

Receivables turnover ratio

Accounts receivable are credit sales made by a company to its customers. For a company, it is essential that it converts accounts receivable to cash. A business’s ability to generate cash from its accounts receivable falls down because of slow-paying customers.

A high ratio will indicate an efficient revenue collection, but a low ratio will indicate the opposite.

Receivables turnover ratio = Net credit sales / Average accounts receivable

Leverage ratios

Companies make use of both short-term and long-term debt to finance their operations. Leverage ratios evaluate how much debt a company has.

The leverage ratio compares the debt amount to the total assets or equity of the company, as listed in its balance sheet or income statement. With this ratio, an investor can understand the company’s financial structure. It can also help loan facilities determine the company’s ability to repay loans.

Leverage ratios

The types of leverage ratios you need to consider are as follows:

Debt ratio

The debt ratio or debt-to-assets ratio compares both the short-term debt obligations as well as long-term debt obligations to the total assets.

If this ratio is high, it represents that the company has a high percentage of debt. Whereas a company that has comparatively lower ratios typically has smaller debts compared to its assets. The latter kind of company will enjoy more flexibility regarding financial decisions since they have fewer financial obligations.

Debt Ratio = Total debt / total assets

Debt to equity ratio

The debt-to-equity ratio, otherwise known as the risk ratio, is useful in calculating the debts of a company. The calculation is based on the total equity, which helps in determining if the company uses a capital structure that includes equity financing.

The higher the value of the debt-to-equity ratio, the more debt the company has. It may also increase the company’s return on equity.

Debt to equity ratio = Total debt / total equity

Interest coverage ratio

Companies usually pay interest on corporate debt. This financial ratio represents if the revenue after operating expenses can cover the company’s interest liabilities.

Interest coverage ratio = EBIT / Interest expenses

Market value ratios

If you wish to measure how valuable your company is, market value ratios can help you. External stakeholders like market analysts or investors generally use these ratios, but internal management also uses these to monitor value per company share.

Earnings per share ratio

The earnings per ratio, or EPS, represents how much profit is attributable to every company share.

The total profit of the company after deducting all expenses, interest and tax is known as net income. Some companies have preferred stock. So, those companies may pay dividends to preferred shareholders before they distribute any earnings to common shareholders.

These preferred dividends have to be subtracted from net income. The resulting figure is divided by the average number of outstanding common shares.

Earnings per share ratio or EPS = (Net income – Preferred Dividends) / End-of-period Common shares outstanding

Price-earnings ratio

The price-earnings ratio measures the price investors are willing to pay for each dollar of a company’s earnings. This is a fundamental ratio that provides insights into how the market values the shares of a company. 

A higher price-earnings (P/E) ratio represents that investors expect higher future growth and are willing to pay a premium for the stock.

However, a lower P/E ratio suggests that either the stock is undervalued or the investors have lower growth expectations.

Price earnings ratio (P/E) = Share Price / Earnings per share

Book value per share ratio

This ratio is a financial metric that is used to measure the accounting value of the common equity of a company on a per-share basis.

It represents the value of the assets, subtracting the liabilities belonging to common shareholders, and then this value is divided by the total number of outstanding common shares. This is also known as net asset value per share or shareholders’ equity per share.

Book value per share ratio = (Total Equity – Preferred Equity) / Total shares outstanding

Dividend yield ratio

The dividend yield ratio measures the annual dividend income an investor can expect to get from the stocks of a company relative to its current market price.

It is a key indicator for income-oriented investors who want regular income from their investments. The value of dividends received for every share owned when a company pays out dividends to shareholders is known as the dividend per share.

Dividend yield ratio = Dividend per share / Share price

Practices for making the most out using financial ratio

Senior management and external stakeholders use financial ratios to measure the performance of the company. The following can help you make the most out of your financial ratio:

  • Comparing financial ratios across periods so that you can identify performance trends.
  • Always make sure that you are computing financial ratios with accurate financial numbers.
  • Ensuring that you use creative competitor and industry benchmarks for measuring performance.
  • Interpreting financial ratios correctly to support key business decisions.
  • Using sheet averages (where applicable) to calculate financial ratios.
  • Calculating and analysing ratios using income statement, balance sheet and cash flow statement for a complete view of the business’s performance.

Making decisions for the company can be a bit challenging, especially with the overwhelming amount of data available. To make use of this information, companies may compare several numbers together, known as ratio analysis. Such analysis lets the company gain better insights into its performance against competition and internal goals over time.

If you wish to get expert advice from professionals in the industry, contact Clear Tax Accountants today.

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