The Most Important Financial Ratios to Consider

Financial ratios are powerful tools used formulate relationships between a company’s financial information. They are calculated by dividing one financial measurement by another. These ratios summarize information taken from financial statements such as the: Balance Sheet , Income Statement and Cash Flow Statement , and can present the health of the company at a given time. It is important to note that these ratios are only valid for the period of time in which they are calculated and that they should be compared to similar time frames. For instance, comparing ratios from before and during Easter will deliver different results.

Information found in company ratios can be used by the company itself for comparison purposes, for example, ratios from the first quarter of last year can be compared to first quarter of the current year to identify any interesting changes and investigate the reasoning behind these. Tracking company performance is a key use of these ratios. For potential investors, financial ratios can be used to compare a company’s performance against its competitors in order to identify the better investment opportunity. These ratios are used by a range of both internal and external stakeholders. Internally, management, employees and owners use these ratios while externally, investors, financial analysts, regulatory and tax authorities, creditors and competitors use these ratios for varying purposes.

There is an endless amount of financial calculations that can be conducted and compared using ratios but some common financial ratios that you are probably familiar with are: return on investment (ROI), current ratio, debt to equity ratio. Deciding which ratios to include in your calculations is purely based on the business size and capabilities. Smaller businesses need only be concerned with a small set of these ratios in order to identify improvement opportunities. The following are the five main categories of financial ratios:

1. Liquidity Ratios
2. Leverage Ratios
3. Efficiency Ratios
4. Profitability Ratios
5. Market Value Ratios

Liquidity ratios demonstrate a company's ability to pay its debts, these may be short or long term as well as other liabilities. These include to cash and other assets that can cover the accounts payable. For small businesses having low liquidity can be a bad sign as it can mean that a company cannot cover its obligations. For a large organization, having a low liquidity could indicate that they need additional capital or an error in management of current funds. Not generating around cash flow to cover debts can lead to financial trouble. The most important liquidity ratios are:

Current Ratio: measures the ability to cover a company's short term liabilities with current assets. A general rule of thumb is that this ratio needs to be 2:1. A lower rate can indicate that the company will not be able to pay its bills on time. A higher rate can indicate that the company could be using its assets more wisely e.g investments.

Current ratio = Current assets / Current liabilities

Quick Ratio: also known as the “acid ration,” and it measures the ability to cover a company’s short term liabilities with quick assets. In the ideal scenario this ratio should be 1:1. If it is higher that can indicate that the company keeps too much cash on hand or have poor collecting for accounts receivable. If it is lower, it can indicate that the company puts too much pressure on stock to meet its obligations.

Acid-test ratio = Current assets - Inventories / Current liabilities

Cash Ratio: this measure the company’s ability to cover its current liabilities if it would have to in a short time frame and therefor with cash and cash equivalents. This calculation produces a result of 1 or above or below 1. If the result is exactly 1, the company has exactly the same amount of cash or cash equivalents as it does current liabilities. If it is higher than 1, that means that the company has more cash or cash equivalents than current liabilities while if it is less than 1, it indicates the opposite. Both of these positions can be positive and negative depending on the individual company’s scenario.

Cash ratio = Cash and Cash equivalents / Current Liabilities

Operating Cash Flow Margin: measures how many times a company can pay off its current liabilities within a given period of time.

Operating cash flow = Operating cash flow / Current liabilities

These ratios measure how much capital comes from debt, indicate a company’s debt levels. It can also evaluate how changes in output can affect operating income.

Debt Ratio: This measures the amount of a company’s capital that is generated by debt. The higher the ratio the more leveraged a company is which can increase financial risk. Debt ratios vary widely from company to company and a good debt ratio in one industry may be acceptable in another. A debt ratio higher than 1 means that your company has more debt than assets.

Debt ratio = Total liabilities / Total assets

Debt to Equity Ratio: this measures the company’s total debt and compares it to capital from investors. A lower ratio is usually safer although if it is too low it can indicate that the company is overly cautious with its money. It must be noted that this ratio is again dependent on industry and company requirements.

Debt to equity = Total liabilities / Shareholder’s equity

Interest Coverage Ratio: this measures how easily a company can handle its interest payments. A higher interest converge ratio can indicate that a company can take on additional debt. This is an important ratio that is considered by bankers and creditors.

Interest coverage = Operating income / Interest expenses

These ratios are used to measure how well a company uses its resources and assets.

Asset Turnover Ratio this ratio measures a company’s ability to use its assets to generate revenue. It is calculated on an annual basis and the higher the ratio is the better the company’s performance. Higher asset turnover ratios indicate that a company is making more revenue per dollar amount of assets.

Asset turnover = Net sales / Total assets

Inventory Turnover Ratio: measures the amount of times a company has sold and replaced inventory in a given period of time. If this ratio is high, it can indicate either strong sales or inadequate stock. On the other hand, a low ratio can indicate weaker sales or overstocking. This is a key performance indicator as the longer a company holds inventory the higher your inventory storage cost and lack of variety for customers. This depends on the type of industry. Businesses can use this ratio to make pricing, marketing, purchasing and manufacturing decisions.

Inventory turnover = Cost of goods sold / Average inventory

Days Sales in Inventory Ratio: this measures how many days a company’s current stock will last. This should be looked at as historical data, as an average from the past because inventory levels are different and different times of the year. Generally, a lower ratio is preferred as it shows that inventory will be cleared in a shorter timeframe, but this ratio can vary across business types.

Days sales in inventory = 365 days / Inventory turnover ratio

Arguably the most well know of the ratio groups the profitability ratios provide insightful information about how a company is performing. These measure the company’s ability to generate income relative to revenue.

Gross Profit Margin: this ratio compares the gross profit to a company’s net sales in order to show the profit that the company is making after paying cost of goods cost. It can indicate the effectiveness of manufacturing or marketing efforts. The higher the margin the more capital the company keeps per dollar of sales.

Gross profit margin = Gross profit / Net sales

Net Profit Margin: measures how much profit a company generates from its revenue. In other words, how much of every dollar that a company collects translates into profit. It is usually expressed as a percentage and therefore any business size can be compared to another. It is a key indicator of the managements effectiveness. Net profit is also referred to as, “the bottom line,” “net margin,” or “net income.” This is one of the most important indicators of a company’s financial position as it includes all business activities.

Net profit: Net Income/Net Sales

Return on Assets Ratio: measured how effectively a company is utilizing its assets to make a profit. A low ROA can indicate inefficient management while a high ROA means the opposite. This ratio can be affected by unusual expenses or depreciation and it is most useful in comparing companies in the same industry as industries use assets differently.

Return on assets ratio = Net income / Total assets

Return on Equity Ratio: measures how well a company is using its equity to make a profit. This ratio is considered as one of the best indicators of profitability in a company. This measure is usually higher than return on assets. This ratio is considered to be the best measure of profitability and is a good to compare to competition or the industry average. A low ratio can indicate a conservative business model or poor management, while a high ratio can indicate good management or need for increased capital investment.

Return on equity ratio = Net income / Shareholder’s equity

These ratios are mainly used to evaluate the share price of a company’s stock and indicate a company’s value.

Earnings Per Share: this shows the company’s profit per share. A company’s profit is divided by the outstanding shares of its common stock. This ratio is also an indication of profitability and is an important component to calculating the price to earnings ratio. This is of particular interest to those seeking to purchase shares in a company.

Earnings per share ratio = Net earnings / Total shares outstanding

Price to Earnings Ratio: is a measure of the value of a company by comparing its share price to its earnings per share. It is also known as the earnings multiple or price multiple and in shortened version it is expressed as: P/E. There are two kinds of P/E ratios: forward and trailing. If the ratio is high, it can indicate that the company’s stock is overvalued or that a high growth rate is expected in the future. A company with no earning or one that is losing money will not have a P/E ratio as there will be no earnings per share.

Price-earnings ratio = Share price / Earnings per share

Dividend Yield Ratio: Measures the amount of dividends paid per share to shareholders over a period of a year. Higher dividend yields are not always good investments as they could be based on a decreasing stock.

Dividend yield ratio = Dividend per share / Share price

Using financial ratios to measure every aspect of business performance can be helpful to avoid decision making pitfalls as well as to compare the company’s performance to its immediate or industry competitors and to track performance over time. It is key that a company does not make decisions based on one ratio alone but rather examines all the ratios together to find those aspects of the business that need improvement which can affect the business performance on a whole. Small businesses should be aware that they should not rely too heavily on ratios as these cannot be the sole driving factor behind decision making but rather a resource to provide a more insightful business decision making process.