When running a business, you need to know how well your enterprise is consistently performing. That kind of knowledge is what can make the difference between its success and failure.
A ratio is a relationship between two specific numerical values that provides a required estimated measurement. Financial ratios, also known as accounting ratios, are accounting values used to measure various business metrics.
The purpose of these accounting ratios is to provide a way to make sense of the financial statements and gauge the performance of a business. When two teams are playing a sports game, you don't need to know all the technicalities of the particular sport. You simply need to look at the score board to tell who is doing well and who is not. Accounting ratios are the business score boards showing broad trends in a company's overall performance.
There are three main ways accounting ratios can help an entrepreneur:
Ratios vary across different industries and to interpret them accurately you need:
These are ratios used to measure the ability of a company to meet its short-term obligations. They are of particular note to creditors they inform them of how capable a business is at repayment of liabilities. These ratios are:
It indicates the number of times current assets of a company can cover the short-term liabilities in case of an emergency. This shows a company's solvency and therefore its degree of strength to weather hard times.
Its formula is: Total current assets / Total current liabilities
A general rule of thumb is to have the current ratio at 2:1. This reflects that:
A safety margin is crucial because while debts are relatively certain the cash value of inventory and the quality of receivable accounts aren't. Therefore, a buffer in being able to settle emergency liabilities is vital. Some ways to improve the current ratio include:
A good current ratio is always positive in value. A high current ratio is indicative of a high liquidity position which lowers the chance of a cash crunch. A current ratio that is too high however indicates ineffective optimization of cash, too much inventory or large account receivables with poor collection policies.
It is also known as the “acid test” ratio, and it is the most stringent liquidity ratio. It compares the more liquid assets against the current liabilities. These liquid assets include cash, short term marketable securities and accounts receivable. The ratio excludes inventory because it isn't quickly convertible into cash.
High inventory during difficult times makes it harder to sell. If a company carries highly specialized or nearly obsolete inventory on its books, it may realize a lower value if it has to dispose of the assets in an emergency compared to the value reflected in the books.
The Quick ratio is formula is: (Total Current Assets - Total Inventory) / Total Current Liabilities
A ratio of 0.50 to 1 is considered acceptable. A level lower than 0.50 may lead to low working capital which will constrain operations. Quick ratio can be improved by:
This ratio is the most reliable although it is also the most conservative of the liquidity ratios. Its formula is:
(cash + short term securities)/current liabilities
Short term securities include bonds, stocks, and option that are held for 12 months or less and are sold quickly during normal market conditions. It is important to note that this ratio can be affected by any significant drop in short term securities in the market.
These ratios are used to measure how well a company is utilizing its assets. They cover a 3 to 5-year period. They assess how many times per year the inventory turns or the receivables collected.
The ratios include:
It measures the number of times inventory converts into sales over a given period. It is also known as Cost of Sales to Inventory ratio. Its formula is:
Cost of Goods Sold / Total Inventory
It worth noting that this is a very industry-specific ratio for example grocery retailers selling perishable goods will have a higher turnover than a furniture retailer selling non-perishable goods. The company's efficiency in making purchases and inventory management reflects through this ratio. An unusually high ratio indicates a lean inventory while a low ratio indicates capital tied up in inventory that can be more efficiently deployed elsewhere.
Improving this ratio is achieved through:
It measures the number of times outstanding funds from customers comes in over a given period. It also measures how many times cash converts into customers' receivables accounts in the same period. Its formula is:
Net Sales / Net Accounts Receivable
A high ratio reflects a faster rate of collection of outstanding cash. Scrutinize the ratio in relation to industry peers for a clearer assessment.
Some ways to improve this ratio include:
A ratio used to measure how fast the firm pays money owed to suppliers or creditors. Its formula is:
Cost of Goods Sold / Inventory
A good balance between how quickly you settle with your creditors within the agreed terms and a maximum use of cash in your business is necessary. Increased purchasing or reduction of accounts payable will increase this ratio.
Some ways to improve this ratio include:
The relationship between your total assets and the profits is made clearer by this ratio. The ratio is a measure of how well your total assets generate revenue and its formulas is:
Profit Before Taxes / Total Assets
Many companies use this ratio to compare their performance to that of industry peers. A lower ratio can indicate a capital-intensive environment or the inefficient use of the company's assets to generate profits.
These ratios provide an analysis of a company's ability to settle its longer-term liabilities. The capital structure of the company alongside the level of financial leverage influence these ratios significantly. Bankers are very keen on assessing these specific class of ratios to discern a company's long-term viability. These ratios include:
The ratio measures the degree to which debt supports the company's total assets as compared to owned equity. Its formula is:
Total Liabilities / Total Assets
A high ratio (typically greater than 1) indicates that lenders own more of the firm's total assets than the owners. Such a position represents a bigger financial risk.
A high ratio can be improved by: paying down debt to reduce exposure to high fixed costs accruing from the interest which will reduce the firm's financial risk.
The risk appetite of the company's management and the type of business it engages in will influence the outlook of this ratio.
Although not considered a real ratio but rather a measure of cash flow, it is a significant indicator of the firm's ability to weather adverse conditions. Lenders pay particular attention to this ratio.
Working capital represents invested resources with a relatively quick rate of turnover minus resources financed by short term debt. Its formula is:
Total Current Assets - Total Current Liabilities
Working capital should be a positive number as a standard. Analyze it in light of other ratios like the Quick ratio or the Current ratio to be more efficient. Some ways to improve working capital include:
It is important to note that loan providers in many instances stipulate a specific level of working capital be maintained if a loan is approved.
The main aim of this ratio is to measure how much a company's capital is dependent on debt. It is also known as Leverage Ratio, and its formula is:
Total Liabilities / Net Worth
A ratio greater than one means that lenders are providing more capital than the owners. Such a ratio is considered high risk by lenders. Steps to reduce the outstanding debt financing the capital should be taken to improve this ratio pro-actively.
Interest Coverage Ratio
The Interest Coverage ratio measures the revenue made by a firm against the interest it is expected to pay. Its formula is:
Earnings Before Interest and Taxes (EBIT) / Interest Payments
A high ratio means that the company can cover its interest payments multiple times over, making it hard to default. The high ratio can indicate increased revenue generated before payment of taxes and interest.
Some ways to improve this can include:
It is important to note that this ratio oscillates in tandem with the prevailing economic climate.
Profitability ratios are accounting metrics used to assess the ability of a firm to generate adequate returns. Profit margins vary across industries and are affected by different dynamics. Any analysis of profitability ratios should take this into consideration.
Commonly used profitability ratios include:
Gross profit margin measures profitability at a very fundamental level. Pricing and product strategies are the backbones of this ratio.
Its formula is: Gross Profit (Revenue - Cost of Goods Sold) / Net Revenue
A ratio that is lower than 1 indicates higher production costs per product than revenue earned per product. You are spending more to produce an item than you are earning from it.
A ratio that is higher than one means lower production costs and higher revenue per product. You are earning more per product than it costs you to make it.
Gross profit can be improved by:
The operating profit margin is used to analyze the relationship between sales and costs influenced by the firm's management.
Its formula is: Operating Income (Gross Income - Operating Expenses) / Net Revenue
This ratio measures the ability of the firm to make money before any debt or taxes are factored in. Analysts use this ratio to compare business efficiency between peer firms.
Increasing operating income is always sought after though consistent and strong operating margins are adequate indicators of good business health.
Some ways to improve the operating margins are:
The net profit income compares a company's net income to its net revenue to measure the conversion of sales into total earnings.
Its formula is: Net Income / Net Revenue
The net profit margin accounts for all expenses and is called the bottom line. Some ways to improve the net profit margin include:
Return on Assets is a measure of how effectively the company utilizes its total assets, and its formula is:
Net Income / Total Assets
A high ratio indicates the ability of the firm to generate revenue against its assets which can be realized by the shareholders.
Return on Assets improves by increasing the efficiency of utilizing the technology, financing or management of inventory by the firm.
Return on Equity is a ratio that measures the level of income that shareholders earn in light of the investment they made into the business. Its formula is:
(Net Income - preferred dividends) / total stockholder's equity
The financial leverage the firm is using is taken into account and can magnify the ratio. A large difference between Return on Assets and Return on Equity points to a significant amount of debt being utilized by the firm. In such a case solvency and liquidity ratios should be analyzed further.
Analyzing different ratios will give you both an overview and an in-depth look at the business and its fundamentals. Financial ratios link various aspects of a business together to deliver a clear and comprehensive representation of a business.