Financial ratios give you tools to understand your business in a simple, direct way.
While they don’t give a complete picture of your business, they’re very useful to, outline strengths and weaknesses, gauge financial health & evaluate profitability.
This guide is also related to our articles on understanding the return on assets formula, how do cash flow forecasting and how to value a small business.
This guide covers
- Important financial ratios
- Financial ratios by industry
- Financial ratio analysis
- Examples of financial ratios
Let’s dive into the numbers together, in a way that makes sense for you and your business.
Basics of Financial Ratios
Simply put, financial ratios are tools that help you understand your business’s financial health by comparing different aspects of your financial statements, such as your income, expenses, assets, and liabilities. These ratios give you insights that raw numbers alone cannot, enabling you to spot trends, identify strengths and weaknesses, and make informed decisions.
Let’s break down the types of financial ratios you’ll find most useful:
Liquidity Ratios: These ratios tell you about your business’s ability to meet its short-term obligations. In other words, can you cover what you owe in the near future? They help ensure you’re not caught off guard by unexpected expenses or slow sales periods.
Solvency Ratios: While liquidity ratios focus on the short term, solvency ratios are all about your long-term viability. They assess your ability to sustain operations indefinitely by examining your debt levels relative to your assets or equity and provide insights into whether you’re using debt wisely or overleveraging yourself.
Profitability Ratios: These ratios evaluate how effectively your business is generating profit from its resources. Ratios such as Gross Profit Margin, Net Profit Margin, and Return on Equity (ROE) reveal the bottom line success of your business operations, helping you understand if your pricing strategies and cost management practices are on point.
Efficiency Ratios: Efficiency ratios, including Inventory Turnover and Accounts Receivable Turnover, measure how well you’re managing your assets. They provide clues on operational performance, such as how quickly you turn inventory into sales or collect payments from customers.
Market Value Ratios: Though more relevant for companies whose stock is publicly traded, these ratios can also offer insights for private businesses by comparing your business’s value to key financial metrics. Market Value Ratios can be benchmarks for evaluating investment attractiveness or the overall market perception of your business.
Liquidity Ratios
Liquidity ratios are your financial first-aid kit. They’re about ensuring your business can handle the unexpected without breaking a sweat. Whether it’s a slow sales month or an unforeseen expense, these ratios provide a clear picture of your ability to pay off short-term debts using your available assets.
Current Ratio = Current Assets / Current Liabilities
This is your go-to metric for assessing liquidity. By dividing your current assets (cash, inventory, receivables) by your current liabilities (debts and obligations due within a year), you get a clear ratio. A current ratio above 1 indicates you have more assets than liabilities, a comforting sign of financial health. However, a ratio too high might suggest that you’re not using your assets efficiently.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
This ratio takes the current ratio a step further by excluding inventory from your current assets. Why? Because inventory isn’t always quick to convert into cash. The quick ratio focuses on your most liquid assets—cash, marketable securities, and receivables—to see if you can meet short-term obligations. A quick ratio closer to 1 or above is ideal, indicating strong liquidity without relying on selling inventory.
Cash Ratio = Cash / Current Liabilities
The most conservative of liquidity measurements, the cash ratio, narrows down your assets to cash and cash equivalents. This ratio tells you about your ability to pay off short-term liabilities immediately with cash on hand, providing a clear picture of your financial resilience without the aid of receivables or inventory.
Why Liquidity Ratios Matter
For small businesses, liquidity is about survival and flexibility. High liquidity ratios mean you can cover your bills and obligations without strain, giving you the freedom to seize opportunities or weather downturns. They reassure you, your suppliers, and potential investors of your business’s health and long-term viability.
However, balance is key. Excessively high liquidity can indicate idle resources that could be invested back into the business for growth.
Solvency Ratios
Solvency ratios take the long-term financial pulse of your business, focusing on its long-term health and its ability to meet long-term obligations. Unlike liquidity ratios, which look at short-term financial stability, solvency ratios delve into the bigger picture: Can your business sustain its operations over time?
Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity
This ratio measures your company’s financial leverage by comparing its total liabilities to shareholders’ equity. A lower ratio suggests your business is using less debt to finance its operations, which is generally seen as positive. However, some industries naturally carry more debt, so context matters.
Interest Coverage Ratio = EBIT / Interest
This ratio indicates how easily your business can pay interest on outstanding debt with its earnings before interest and taxes (EBIT). A higher ratio shows that your business can comfortably cover its interest payments, a good sign of financial health.
Debt Ratio = Total Liabilities / Total Assets
The debt ratio offers a straightforward look at your company’s leverage. It tells you what portion of your assets is financed by debt. A ratio less than 1 indicates that a majority of assets are financed through equity, which is preferable.
Why Solvency Ratios Matter
Solvency ratios, such as the Debt to Equity Ratio and Interest Coverage Ratio, are pivotal for small business owners. They help small businesses manage debt responsibly and signal financial health to potential investors. For instance, a boutique owner using the Debt to Equity Ratio can assess if they’re relying too much on borrowed funds versus their own investment to finance the store. A healthy ratio assures lenders the business is a safe bet for additional loans.
Profitability Ratios
Profitability ratios are the scorecards showing how well your business is performing in terms of generating earnings relative to various aspects of its operations, such as sales, assets, and equity. These ratios are reflections of your business strategy’s effectiveness, pricing policies, and overall operational efficiency.
Gross Profit Margin = (Gross Profit / Sales) x 100
This ratio reveals the efficiency of your production process by comparing gross profit (sales minus cost of goods sold) to sales. A higher percentage means you’re retaining more from each dollar of sales to cover other costs.
Operating Profit Margin = (Operating Income / Sales) x 100
It measures the percentage of income left after removing cost of goods sold and operating expenses. This ratio indicates how well you’re managing your day-to-day operations and controlling costs.
Net Profit Margin = (Net Income / Sales) x 100
This is what remains from sales after all expenses are deducted. It shows the bottom line efficiency of your business in turning sales into actual profit.
Return on Assets (ROA) = (Net Income / Total Assets) x 100
ROA shows how efficiently your business uses its assets to generate profit, calculated as:. A higher ROA indicates more efficient use of assets. Click here for a more in-depth treatment of Return on Assets.
Return on Equity (ROE) = (Net Income / Shareholder’s Equity) x 100
This ratio measures how effectively management is using a company’s ???? to create profits. A higher ROE suggests a more efficient use of equity.
Why Profitability Ratios matter
Profitability isn’t just about making money—it’s a measure of success and sustainability. High profitability ratios are a clear indicator that your business is doing well, generating more revenue than expenses. They help you pinpoint areas where you can reduce costs, adjust pricing, or optimize operations to boost profitability.
Efficiency Ratios
Efficiency ratios are the unsung heroes in the world of financial metrics, shining a light on how adeptly your business manages its assets and liabilities. These ratios are crucial for pinpointing areas where operations could be streamlined, whether it’s speeding up inventory sales or ensuring that receivables are collected more promptly.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
This ratio measures how often your business sells and replaces its inventory over a period of time you’re measuring, such as a month or a year. It helps you understand if you’re efficiently managing your stock. Higher turnover indicates effective inventory management and less money tied up in unsold goods.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Net credit sales are sales you make where you don’t collect the cash upfront. This ratio highlights how effectively your business collects debts. A higher ratio signifies efficient collection practices, meaning that your sales are quickly converted into cash.
Asset Turnover Ratio = Sales / Total Average Assets
This measures how efficiently your business uses its assets to generate sales. A higher ratio means your business is using its assets efficiently to produce revenue.
Why Efficiency Ratios Matter
For an example of how efficiency ratios are useful, a small retail shop tracking its Inventory Turnover Ratio can identify how quickly merchandise is sold and replaced, ensuring that capital isn’t tied up in unsold stock.
Similarly, a service-based business, such as a consulting firm, might use the Accounts Receivable Turnover Ratio to measure how efficiently it collects payments from clients, crucial for maintaining healthy cash flow. These ratios show businesses if they need to streamline operations, improve cash management, optimize resource use, and reduce waste.
Market Value Ratios
While small businesses might not be publicly traded, understanding these ratios can provide valuable perspectives on how your business might be valued and how to assess potential investments or partnerships.
Price to Earnings (P/E) Ratio = Share Price / Earnings Per Share
This ratio compares a company’s share price to its earnings per share (EPS). A high P/E ratio could indicate that the market expects high growth rates in the future, whereas a low P/E might suggest the stock is undervalued or that the company is experiencing difficulties.
Price to Book (P/B) Ratio = Share Price / Book Value Per Share
P/B ratio compares a company’s market capitalization to its book value. This ratio provides insights into how much shareholders are paying for the net assets of the company. A lower ratio could indicate a potentially undervalued stock, while a higher ratio might reflect investors’ expectations for future growth.
Dividend Yield = Annual Dividends Per Share / Share Price
This ratio shows how much a company pays out in dividends each year relative to its share price. It’s particularly relevant for investors seeking income through dividends, providing a measure of the return on investment from dividend payments alone.
Earnings Per Share (EPS) = Net Income / number of shares outstanding
EPS is a direct measure of a company’s profitability on a per-share basis. It measures the amount of a company’s profit that can be assigned to one share of its stock. It offers investors a snapshot of a company’s financial health and profitability.
Financial Ratios Cheat Sheet
Liquidity Ratios
- Current Ratio: Current Assets / Current Liabilities
- Quick Ratio (Acid-Test Ratio): (Current Assets – Inventory) / Current Liabilities
- Cash Ratio: Cash and Cash Equivalents / Current Liabilities
Solvency Ratios
- Debt to Equity Ratio: Total Liabilities / Shareholders’ Equity
- Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expenses
- Debt Ratio: Total Liabilities / Total Assets
Profitability Ratios
- Gross Profit Margin: (Gross Profit / Sales) x 100
- Operating Profit Margin: (Operating Income / Sales) x 100
- Net Profit Margin: (Net Income / Sales) x 100
- Return on Assets (ROA): (Net Income / Total Assets) x 100
- Return on Equity (ROE): (Net Income / Shareholder’s Equity) x 100
Efficiency Ratios
- Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory
- Accounts Receivable Turnover Ratio: Net Credit Sales / Average Accounts Receivable
- Asset Turnover Ratio: Sales / Average Total Assets
Market Value Ratios
- Price to Earnings (P/E) Ratio: Share Price / Earnings Per Share (EPS)
- Price to Book (P/B) Ratio: Share Price / Book Value Per Share
- Dividend Yield: Annual Dividends Per Share / Share Price
- Earnings Per Share (EPS): Net Income / Number of Shares Outstanding
Conclusion
By understanding and applying key ratios like liquidity, solvency, profitability, efficiency, and market value ratios, you can:
- Diagnose Financial Health: Quickly gauge your business’s ability to meet short-term obligations and ensure long-term viability.
- Benchmark Performance: Compare your business’s performance against past periods and industry standards to identify areas of strength and opportunities for improvement.
- Make Informed Decisions: Use insights from financial ratios to make strategic decisions about operational adjustments, financial planning, and investment opportunities.
- Enhance Profitability: Identify inefficiencies and areas for cost reduction, optimize pricing strategies, and improve overall operational efficiency.
Remember, while financial ratios offer profound insights, they’re most powerful when used in conjunction with a comprehensive understanding of your business environment, industry trends, and macroeconomic factors.
So, dive into the numbers, but keep your strategic vision in the forefront as you navigate the path to business growth and profitability.
Next, check out our articles on 15 best accounting books to read in 2023, how to hire a virtual bookkeeper, and top 10 ecommerce platforms.
FAQ: Financial ratios formulas
Here's some answers to commonly asked questions about financial ratio formulas.
What are financial ratios?
Financial ratios are calculations derived from a company’s financial statements, providing insights into its operations, liquidity, profitability, and solvency. These ratios help stakeholders assess the company’s financial health and operational efficiency.
How can financial ratios be used?
Financial ratios allow for a comprehensive analysis of a company’s financial condition by comparing different financial metrics. Ratios like the current ratio, debt-to-equity ratio, and return on equity provide snapshots of liquidity, financial leverage, and profitability, helping to identify potential financial strengths or weaknesses.
Are financial ratios equally important across all industries?
No, the importance of financial ratios can vary significantly across different industries due to varying business models and capital requirements. For example, inventory turnover is crucial for retail, while debt-to-equity might be more critical for manufacturing. It’s essential to compare ratios within the same industry for accurate benchmarking.
