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Financial Ratios Calculator

Understand the Numbers Driving Your Business
This calculator is designed to show you 10 different financial ratios. Financial ratios are used as indicators that allow you to zero in on areas of your business that may need attention such as solvency, liquidity, operational efficiency and profitability.

 

Understanding Financial Ratios

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.

Business Accounts.

The Importance of Financial Ratios

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:

  1. They help compare the present performance of the business to past periods. These could be past business quarters or years. You can tell how the business is doing over a given period.
  2. The help you identify areas that need improvising a business or potential problem areas to avoid altogether.
  3. They help you measure a company's performance against its competitors or industry peers. This can be a useful guide when setting strategy for competitive advantage.

Ratios vary across different industries and to interpret them accurately you need:

  • In-depth knowledge of the sector the business under review operates in.
  • In-depth knowledge of the firm whose financial information is under consideration.
  • The reason for fluctuations reflected by the information presented. The deep industry and specific business knowledge information are what will help you accurately identify the causes of these variations.

Types of Financial Ratios and How to Improve Them

Liquidity Ratios

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:

  • Current ratio.
  • Quick ratio.
  • Cash ratio.

Current Ratio

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:

  • The company is utilizing cash well by not having too much of it hand.
  • The company has a margin of safety in covering its short-term obligations.

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:

  • Paying down existing debt to reduce the total current liabilities.
  • Selling fixed assets to increase the value of total current assets.
  • Reinvesting the profits to increase the current assets and reduce excess cash at hand.
  • Acquiring long term loans with a duration of one year or more.

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.

Quick Ratio

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:

  • Ensuring the rate of collection of accounts receivable doesn't slow down.
  • Ensuring that accounts receivable aren't left to balloon before collection takes place.

Cash Ratio

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.

Efficiency or Activity Ratios

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:

  • Inventory turnover.
  • Receivables turnover.
  • Payables turnover.
  • Asset turnover.

Inventory Turnover

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:

  • Purchasing more inventory in lean situations to better keep up with customer demand.
  • Selling of excess inventory at a discount to customers to offload obsolete inventory and release capital that can be used elsewhere in the business more effectively.

Receivables Turnover

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:

  • Easing the credit policies a little in the case of too high a ratio as this indicates the firm could be missing out on potential sales opportunities.
  • Tightening the collection policies in the case of a lower ratio as this shows that customers aren't paying their bills when they are due. Such a situation can lead to a cash crunch if unchecked.

Payables Turnover

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:

  • Utilizing extended credit better if the ratio is unusually high and gain more use out of cash staying in business for long.
  • Tightening policies on settling payable accounts if the ratio is unusually low to avoid negative any impact with creditors.

Asset Turnover

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.

Solvency Ratios

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:

  • Debt-to-assets ratio.
  • Working capital.
  • Debt-to-equity ratio.
  • Interest coverage ratio.

Debt-to-Assets Ratio

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.

Working Capital

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:

  • Generating increased revenue to boost total assets.
  • Issuing more stock (common or preferred) for cash, thereby increasing assets.
  • Paying short-term debts for lesser than the outstanding amounts to reduce liabilities.
  • Selling long-term assets for cash to increase assets.
  • Substituting short-term debt with long-term debt.

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.

Debt-to-Worth Ratio

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:

  • Increasing the the firm's revenue.
  • Reducing the interest payments due.
  • Finding legal ways to reduce the company's tax burden.

It is important to note that this ratio oscillates in tandem with the prevailing economic climate.

Profitability Ratios

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.
  • Operating profit margin.
  • Net profit margin.
  • Return on Assets.
  • Return on equity.

Gross Profit Margin

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:

  • Reducing the costs associated with producing your products.
  • Increasing sales through strategies that give your product competitive advantage, for example, better branding, differentiation, increased quality, etc.

Operating Profit Margin

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:

  • Increasing the revenue generated from sales.
  • Reducing the costs of production through greater operational efficiency for example labor, the cost of inputs, etc.

Net Profit Margin

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:

  • Assessing the product lineup and how it relates to revenue earned. The firm should select and focus on products that can earn a higher margin per sale.
  • Reducing operational costs by minimizing wastage and increasing efficiency.
  • Segmenting the customers to serve those clients who need the product the most, are willing and able to pay a good price for it and can be served at a cheaper cost.

Return on Assets

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

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.

Conclusion

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.