Financial ratios, also known as accounting ratios or finance ratios, are used by businesses to assess liquidity, debt concentration, growth, profitability, and market value. Financial ratios are important for understanding how a company generates revenue and profits using its expenses and assets, and are used by internal and external stakeholders for competitor analysis, market valuation, benchmarking, and performance management.
Financial ratios inside a business
Analysis of financial ratios serves two main purposes:
1) Track company performance
Tracking the change in a company’s financial ratios over time can help to identify trends that may be developing. For example, an increasing debt-to-asset ratio may indicate that a company is becoming more heavily indebted and may be at risk of default. By monitoring these ratios, businesses can identify potential problems and take action to address them before they become more serious.
2) Make comparative judgments regarding company performance
Comparing a company’s financial ratios to those of its competitors can provide important information about its relative performance. For example, by comparing the return on assets of different companies, investors and analysts can determine which company is using its assets most efficiently. This comparison type can help businesses identify areas where they may need to improve and provide valuable insights for investors and analysts.
There are two main categories of users of financial ratios: external users and internal users.
- External users include financial analysts, investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers.
- Internal users include a company’s management team, employees, and owners.
5 Essential Financial Ratios for Every Business
Financial ratios are grouped into the following categories:
1) Liquidity ratios
Liquidity ratios are financial ratios that measure a company’s ability to meet its short-term and long-term obligations. These ratios are important for assessing a company’s financial health and its ability to pay its bills on time. Common liquidity ratios include:
The current ratio measures how a business’s current assets, such as cash, cash equivalents, accounts receivable, and inventories, are used to settle current liabilities such as accounts payable.
Current ratio = Current assets / Current liabilities
The acid-test ratio, also known as the quick ratio, is a financial ratio that measures a company’s ability to cover its current liabilities using its most liquid assets. This ratio is calculated by dividing a company’s current assets, excluding inventories, by its current liabilities.
A quick ratio of 1 is considered the industry average, and a ratio below 1 indicates that a company may not be able to meet its current obligations because it has insufficient liquid assets to cover its liabilities. This ratio is used to assess a company’s liquidity risk and its ability to pay its bills on time. A low quick ratio may be a warning sign for investors and creditors, who may view the company as being at risk of default.
Acid-test ratio = Current assets – Inventories / Current liabilities
The cash ratio measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities. This ratio shows how quickly a company can settle current obligations.
Cash ratio = Cash and Cash equivalents / Current Liabilities
The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period.
Operating cash flow ratio = Operating cash flow / Current liabilities
2) Leverage ratios
Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include:
The debt ratio measures the proportion of debt a company has to its total assets. A high debt ratio indicates that a company is highly leveraged.
Debt ratio = Total liabilities / Total assets
The debt-to-equity ratio measures a company’s debt liabilities relative to its shareholders’ equity. This ratio provides important information about a company’s financial risk and its use of debt to finance its operations. The debt-to-equity ratio is calculated by dividing a company’s total debt by its shareholders’ equity. A high debt-to-equity ratio indicates that a company has a high level of debt relative to its equity, and may be at greater risk of default if it is unable to make its debt payments. This ratio is important for investors because debt obligations have a higher priority than equity in the event of bankruptcy, and a high debt-to-equity ratio may indicate that investors’ returns are at greater risk.
Debt to equity ratio = Total liabilities / Shareholder’s equity
Companies generally pay interest on corporate debt. The interest coverage ratio shows if a company’s revenue after operating expenses can cover interest liabilities.
Interest coverage ratio = Operating income / Interest expenses
The debt service coverage ratio reveals how easily a company can pay its debt obligations.
Debt service coverage ratio = Operating income / Total debt service
3) Efficiency ratios
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:
Companies use assets to generate sales. The asset turnover ratio measures how much net sales are made from average assets.
Asset turnover ratio = Net sales / Average total assets
For companies in the manufacturing and production industries with high inventory levels, inventory turnover is an important ratio that measures how often inventory is used and replaced for operations.
Inventory turnover ratio = Cost of goods sold / Average inventory
Accounts receivables are credit sales made to customers. It is important that companies can readily convert account receivables to cash. Slow-paying customers reduce a business’s ability to generate cash from their accounts receivable.
The receivables turnover ratio helps companies measure how quickly they turn customers’ invoices into cash. A high receivables turnover ratio shows that a company quickly generates cash from accounts receivables.
Receivables turnover ratio = Net credit sales / Average accounts receivable
Holding inventory for too long may not be efficient. The day sales in inventory ratio calculates how long a business holds inventories before they are converted to finished products or sold to customers.
Days sales in inventory ratio = 365 days / Inventory turnover ratio
4) Profitability ratios
Profitability ratios are financial ratios that measure how efficiently a company generates profits using its available resources. These ratios provide important information about a company’s profitability and its ability to generate returns for its shareholders. To calculate a company’s profit, net sales are subtracted from expenses. Higher profitability ratio results are generally considered more favorable, but these ratios provide more valuable information when they are compared to the results of similar companies, the company’s own historical performance, or the industry average. By comparing profitability ratios, businesses can identify areas where they may need to improve and benchmark their performance against that of their competitors. Common profitability ratios include:
The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold.
Gross margin ratio = Gross profit / Net sales
The operating margin ratio, sometimes known as the return on sales ratio, compares the operating income of a company to its net sales to determine operating efficiency.
Operating margin ratio = Operating income / Net sales
Companies use the return on assets ratio to determine how much profit they generate from total assets or resources, including current and noncurrent assets.
Return on assets ratio = Net income / Total assets
Shareholders’ equity is capital investments. The return on equity ratio measures how much profit a business generates from shareholders’ equity. For instance, a company with a declining ROE could be seen as having more risk than a company in the same industry with an increasing ROI.
Return on equity ratio = Net income / Shareholder’s equity
5) Market value ratios
Market value ratios are used to evaluate how valuable a company is. These ratios are usually used by external stakeholders such as investors or market analysts but can also be used by internal management to monitor value per company share. Common market value ratios include the following:
A company’s common equity is what common shareholders own after all liabilities and preference shares have been settled from total assets.
The book value per share ratio measures the value per share for common equity owners based on the balance sheet value of assets less liabilities and preference shares.
Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding
The dividend yield ratio measures the value of a company’s dividend per share compared to the market share price.
When companies pay out dividends to shareholders, the value of dividends received for each share owned is known as the dividend per share. Shareholders and analysts compare the dividend per share to the company’s share price using the dividend yield ratio.
Dividend yield ratio = Dividend per share / Share price
The earnings per share ratio, also known as EPS, shows how much profit is attributable to each company share.
Earnings per share ratio = Net earnings / Total shares outstanding
The PE ratio is a key investor ratio that measures how valuable a company is relative to its book value earnings per share.
Price-earnings ratio = Share price / Earnings per share
Conclusion
Financial ratios can provide valuable insights into a company’s performance and should not be ignored. By accurately calculating and interpreting these ratios, business leaders and investors can make more informed decisions. Comparing a company’s ratios to those of its competitors and the industry can help provide a broader picture of its performance over time. Finance teams who want to dig deeper into financial ratios and learn best practices for using them should check out Datarails blog that was uploaded earlier this year.
