Financial ratios are an important tool in any business owner’s toolbox. Used to measure a business’s condition and performance, financial ratios help you evaluate your organization’s financial status and rate of success. They are also used by those evaluating your business for potential investment or lending opportunities.
Generally speaking, there are four categories of financial ratios: liquidity, profitability, activity, and leverage. Your balance sheet and income statement will help you calculate the ratios within each category.
Liquidity ratios assess your organization’s ability to meet its obligations in the short term. Put simply, liquidity measures your firm’s ability to pay its bills.
Current ratio: This measures the amount of debt relative to total assets (total assets divided by total liabilities). A current ratio of at least 1 (ideally, greater) indicates your business has enough assets to cover its current obligations.
Acid test or quick ratio: This ratio measures your organization’s ability to pay its current obligations with accessible assets. In other words, it helps you assess its “cash position.” The calculation is (cash and cash alternatives plus marketable securities plus accounts receivable) divided by current liabilities. The higher the ratio, the stronger its position. A low ratio could indicate a potential cash crunch.
These ratios help measure how profitable your organization is.
Gross profit margin: This ratio determines how much remains after accounting for the cost of goods sold (COGS) to pay for expenses, taxes, interest, etc. It is calculated by dividing gross profit by sales. (Gross profit equals sales minus COGS.)
Net profit margin: Net profit allows you to gauge how well your company is performing per dollar of revenue. It is calculated by dividing net income (income after expenses) by net revenue (revenue after adjusting for discounts and refunds). While growing revenue year over year can be impressive, growing revenue alongside a growing net profit margin demonstrates strong overall management.
Return on assets: Calculated by dividing net income by average total assets, this ratio shows the organization’s ability to generate income relative to overall assets. Therefore, it helps gauge management effectiveness in putting those assets to use. (To calculate average total assets, add the total assets at the beginning and end of the year and divide by two.)
Also known as efficiency ratios, activity ratios measure how effectively your organization manages its assets.
Accounts receivable turnover ratio: This ratio is used to evaluate the quality of receivables and to help determine how successful your organization is in collecting outstanding payments. It is determined by dividing net sales by average receivables outstanding over a given time period. (Average receivables outstanding is calculated by adding the beginning and ending balances of accounts receivables over a period of time and dividing by two.)
Inventory turnover ratio: This ratio can help determine whether your company is efficiently managing inventory. It is calculated by dividing the COGS by the average inventory (the average of the beginning and ending inventories over a period of time). A high ratio may indicate that inventory typically runs low and may present a risk of “selling out.” By contrast, a low ratio may indicate that product is overstocked or not moving well for a particular reason that might warrant further investigation.
Also known as debt, coverage, or solvency ratios, leverage ratios can help assess whether debt levels are appropriate.
Debt to asset ratio: This ratio measures the percentage of assets that is financed with debt, rather than equity. The calculation is total debt divided by total assets.
Debt to equity ratio: This ratio compares an organization’s total debt to its total equity. The calculation is total liabilities divided by total equity. A high ratio may indicate a business has assumed a great deal of risk.
Understand your industry’s benchmarks
Before evaluating your organization’s financial ratios, it may be helpful to understand ratio benchmarks within your industry. What may seem like a high or low ratio on its own may actually be in line with other, similar operations in your field.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2019