What are Financial Ratios?
Running a business, whether large or small, means that having a good grasp on all financial aspects that are part of ensuring business success is essential.
One of the best ways to determine the business’ financial performance is through financial ratios. Financial ratios are numerical values that measure the relationship between two or more components, which is determined by using the data found on a business’s financial statements, such as the balance sheet, income statement, and cash flow statement.
These values will help determine a range of ratios that will discover things, such as a business’s profitability, liquidity, operational efficiency, and solvency, which are essential to understanding and optimising business performance.
What are Financial Ratios Used For?
For companies and businesses, financial ratios are often used to present easy-to-understand information to investors or banks and financial institutions.
This helps external parties grasp the financial status of a business when requesting funding from an investor or applying for loans. And it’s not just for companies that operate on a large scale. Financial ratios are important for small businesses as well, especially start-ups looking for investor funding or needing to be granted a financial loan.
Financial ratios are also important for internal business processes. These ratios are useful for conducting analyses that provide meaningful data about a business and its financial stability. It can help track performance, identify any financial difficulties, save money and help set goals and KPIs and show future earnings.
Over time, keeping track of these values can help identify trends that show how the business is performing and its financial position. For example, monitoring the debt to asset ratio over time will help prevent the business from becoming at risk of default. They can also help with comparing the business benchmarks to other competitors and industry averages. This is especially relevant for new businesses or those in competitive industries.
What Do Financial Ratios Measure?
Financial ratios measure the profitability, liquidity, operational efficiency, and solvency of a business. Examples of these ratios are listed below.
Profitability Ratios
Profitability can be defined as the measure of a business’s profit compared to its expenses. The efficiency of a business is related to its profitability. Financial ratios that measure profitability are listed below. The numerical values needed for the profitability ratios are found on the business income statement.
Gross Profit Margin Ratio
Having a gross profit margin with a higher value shows that the product or service being sold is being converted into a profit. This financial ratio requires knowing two numerical values: the total cost of producing the product/service, including labour and materials — cost of goods sold — and net sales, which is the revenue, minus returns and discounts.
Gross Profit Margin = net sales – cost of goods sold/net sales x 100
Net Profit Margin Ratio
A net profit margin with a higher value means that the business converts sales into a profit. The net profit of a business is determined by deducting all operating, tax, and interest expenses from the amount of money earned.
Net Profit Margin = net profit/sales x 100
Operating Profit Margin Ratio
Higher operating profit margins show that the business has efficient management and a good ratio of operating costs. Knowledge of a business’s gross profit is required for analysing this profit ratio. This is calculated by subtracting all manufacturing and operating expenses from the revenue.
Operating Profit Margin = gross profit – operating expenses/revenue x 100
Return on Equity Ratio
This financial ratio is for investors and calculates the rate of return on investments they will receive from their equity in the business.
Return On Equity = net profit/shareholder’s equity
Liquidity Ratios
The following ratios refer to accounting liquidity, which is the ability of a business to turn current assets into cash or the ease at which they could pay off any short-term obligations. The data required to analyse these ratios would be found on the balance sheet and cash flow statement. A ratio greater than 1 shows good measures of liquidity.
Working Capital/Current Ratio
This ratio is to determine if a business’s assets exceed its financial liabilities and thus its ability to pay off short-term liabilities.
Working Capital Ratio = current assets/current liabilities
Cash Ratio
This ratio is a similar measurement to a working capital ratio, but only measures cash and cash equivalents that do not include inventory.
Cash Ratio = cash & cash equivalents/current liabilities
Quick Ratio or Acid-Test Ratio
The quick ratio measures how well a business can turn current assets into cash in order to pay outstanding debts.
Quick Ratio = current assets – inventory – prepaid expenses/current liabilities
Cash Flow to Debt Ratio
This ratio determines if a business’s operating cash flow suffices to pay off any business liabilities. The operating cash flow calculation is total revenue – operating expenses.
Cash Flow to Debt Ratio = operating cash flow/current liabilities
Operating Cash Flow to Net Sales Ratio
This number should stay consistent as sales increase as it measures how much cash the business can make in relation to its sales.
Operating Cash Flow to Net Sales = operating cash flow/net sales
Free Cash Flow to Operating Cash Flow Ratio
A high free cash flow is desired by shareholders and a higher ratio means financial stability for the business. Free cash flow is calculated by cash from operations – capital expenditures.
Free Cash Flow to Operating Cash Flow Ratio = free cash flow/operating cash flow
Operational Efficiency
These ratios determine how effectively a business is using its assets and resources.
Revenue per Employee
Measures effectiveness of employees in relation to revenue.
Revenue per Employee = annual revenue/annual number of employees
Return on Total Assets
Measures the ability to generate sales from assets.
Return on Total Assets = net income/net total assets
Inventory Turnover
Measures the efficiency of the business’s ability to sell and replace inventory.
Inventory Turnover = cost of goods sold/average inventory
Accounts Receivable Turnover Ratio
Measures the rate of collections. A higher ratio means customers are paying more quickly.
Accounts Receivable Turnover = net annual credit sales/average accounts receivable
Solvency or Leverage Ratios
Solvency measures the business’s ability to pay any long-term debt. Values from the balance sheet are used for these ratios.
Debt to Equity Ratio
Shows the business’s ability to pay off any loans.
Debt to Equity Ratio = total liabilities/shareholder’s equity
Debt to Asset Ratio
This ratio measures how many of a business’s assets are financed from loans. A high ratio could indicate financial trouble.
Debt to Asset Ratio = total liabilities/total assets
Still, Confused?
There is good news. While these analyses are important to running a successful business, they can be automated by using business accounting software. Talk to a local accountant or, for those based in Australia, you could speak to a professional albany accountant at The Accounting Centre for more information on financial ratios, get taxation help or about help in business overall!
