What are financial ratios?
Financial ratios are basic calculations using quantitative data from a company’s financial statements. They are used to get insights and important information on the company’s performance, profitability, and financial health.
Common financial ratios come from a company’s balance sheet, income statement, and cash flow statement.
Businesses use financial ratios to determine liquidity, debt concentration, growth, profitability, and market value.
Why are financial ratios so important?
Financial ratios are sometimes referred to as accounting ratios or finance ratios. These ratios are important for assessing how a company generates revenue and profits using business expenses and assets in a given period. Internal and external stakeholders use financial ratios for competitor analysis, market valuation, benchmarking, and performance management.
Financial Ratios inside a business
Financial planning and analysis professionals calculate financial ratios for the following reasons for internal reasons.
● To measure return on capital investments
● To calculate profit margins
● To assess a company’s efficiency and how costs are allocated
● To determine how much debt is used to finance operations
● To identify trends in profitability
● To manage working capital and short-term funding requirements
● To identify operating bottlenecks and assess inventory management systems
● To measure a company’s ability to settle debt and liabilities
How analysts and external stakeholders use Financial Ratios
External stakeholders use financial ratios to:
● Carry out competitor analysis
● Determine whether to finance a company in the form of debt
● Assess how profitable a company is
● Determine whether to provide equity financing or buy shares in the company
● Calculate tax liabilities
● Measure a company’s market value
● Calculate return on shareholders’ equity
● Perform market analysis
5 Essential Financial Ratios for Every Business
The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.
1) Liquidity ratios
Companies use liquidity ratios to measure working capital performance – the money available to meet your current, short-term obligations .
Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a company’s capacity to meet its short-term obligations and are a vital indicator of its financial health. Liquidity is different from solvency, which measures a company’s ability to pay all its debts. In the sporting world, Italian football club Lazio faces a now-infamous liquidity ratio preventing it from signing new players. Italian clubs are required to communicate their liquidity indicator to the football authorities twice a year. This indicator cannot be any lower than a certain threshold set by the football authorities.
There are different forms of liquidity ratio.
Current ratio: Current Assets / Current Liabilities
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.
Quick ratio (Acid-test ratio): Current Assets – Inventories / Current Liabilities
Also known as the acid-test ratio, the quick ratio measures how a business’s more liquid assets, such as cash, cash equivalents, and accounts receivable can cover current liabilities. This ratio excludes inventories from current assets. A quick ratio of 1 is considered the industry average. A quick ratio below 1 shows that a company may not be in a position to meet its current obligations because it has insufficient assets to be liquidated. (Acid test refers to a quick and simple test gold miners used to determine whether samples of metal were true gold or not. Acid would be added to a sample; if it dissolved, it wasn’t gold. If it stood up to the acid, it likely was). From a great real example on the Street.com see how Apple’s Quick Ratio stacks up:
Quick Ratio Example: Apple (NASDAQ: AAPL)
The following figures are as of March 27th, 2021, and come from Apple’s balance sheet. Numbers are in millions of dollars.
Cash and cash equivalents: $38,466
Accounts receivable: $18,503
Marketable securities: $31,368
Current liabilities: $106,385
QR = Liquid Assets / Current Liabilities
QR = ($38,466 + $18,503 +$31,368) / $106,385
QR = $88,337 / $106,385
QR = 0.83
Based on this calculation, Apple’s quick ratio was 0.83 as of the end of March 2021. This number could be higher if more assets were included in its calculations.
Cash ratio: Cash and cash equivalents / 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.
2) Leverage ratios
Companies often use short and long-term debt to finance business operations. Leverage ratios measure how much debt a company has. Molson Coors Beverage Co. , the maker of Coors Light and Miller Lite beer for instance, had been saddled with debt, after an acquisition in the industry according to the Wall Street Journal. Its CFO Tracey Joubert signaled to the market the company’s plans “reduce its leverage ratio to below 3 times by the end of this year.” The types of leverage ratio to consider are:
Debt ratio: Total Debt / Total Assets
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 to equity ratio: Total Debt / Total Equity
The debt-to-equity ratio measures a company’s debt liability compared to shareholders’ equity. This ratio is important for investors because debt obligations often have a higher priority if a company goes bankrupt.
Interest coverage ratio: Operating income / Interest expenses
Companies generally pay interest on corporate debt. The interest coverage ratio shows if a company’s revenue after operating expenses can cover interest liabilities.
3) Efficiency ratios
Efficiency ratios show how effectively a company uses working capital to generate sales. For instance an analyst reported that Seattle-based bank Washington Federal’s company’s efficiency ratio was 58.65%, down from 59.02% recorded a year ago. A fall in efficiency ratio indicates improved profitability. There are several ways to analyze efficiency ratios:
Asset turnover ratio: Net sales / Average total assets
Companies use assets to generate sales. The asset turnover ratio measures how much net sales are made from average assets.
Inventory turnover: Cost of goods sold / Average inventory
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.
Days sales in inventory ratio: 365 days / Inventory turnover ratio
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.
Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average Accounts Payable
The payables turnover ratio calculates how quickly a business pays its suppliers and creditors.
Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period (or year)
This ratio shows how many days it takes a company to pay off suppliers and vendors. A lower days payables outstanding implies that a business is letting go of cash too quickly and may not be taking advantage of longer credit terms. On the other hand, when the DPO is too high, it means a company delays paying its suppliers, which can lead to disputes.
Receivables turnover ratio: Net credit sales / Average accounts receivable
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.
4) Profitability ratios
A business’s profit is calculated as net sales less expenses. Profitability ratios measure how a company generates profits using available resources over a given period. Higher ratio results are often more favorable, but these ratios provide much more information when compared to results of similar companies, the company’s own historical performance, or the industry average. Some of the most common profitability ratios are:
Gross margin: Gross profit / Net sales
The gross margin ratio measures how much profit a business makes after the cost of goods and services compared to net sales. Comparing companies can be illustrative – such as finding that Home Depot has a 33.6% gross profit margin versus Walmart’s 25.1%.
Operating margin: Operating income / Net sales
The operating margin measures how much profit a company generates from net sales after accounting for the cost of goods sold and operating expenses.
Return on assets (ROA): Net income / Total assets
Companies use the return on assets ratio to determine how much profits they generate from total assets or resources, including current and noncurrent assets.
Return on equity (ROE): Net income / Total equity
Shareholders’ equity is capital investments. The return on equity 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.
5) Market Value ratios
Market value ratios are used to measure 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.
Earnings per share ratio (EPS): Net earnings / Total shares outstanding
The earnings per share ratio, also known as EPS, shows how much profit is attributable to each company share.
Price earnings ratio (P/E): Share price / Earnings per share
The PE ratio is a key investor ratio that measures how valuable a company is relative to its book value earnings per share.
Book value per share ratio: Total Equity – Preferred Equity / Total shares outstanding
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 measures the value per share for common equity owners based on the balance sheet value of assets less liabilities and preference shares.
Dividend yield ratio: Dividend per share / Share price
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.
Best Practices For Using Financial Ratios
Financial ratios help senior management and external stakeholders measure a company’s performance. These best practices will drive effective decision-making.
● Compute financial ratios with accurate financial numbers
● Compare ratios across periods to identify performance trends
● Use relative competitor and industry benchmarks to measure performance
● Calculate ratios using balance sheet averages where applicable
● Interpret financial ratios correctly to support key business decisions
Financial ratios are good key performance indicators used to measure a company’s performance over time compared to competitors and the industry. Calculating accurate financial ratios and interpreting the ratios help business leaders and investors make the right decisions.