Back to the Basics: Understanding Financial Ratios

understanding financial ratios

Understanding financial ratios is essential to cultivating a healthy business. Between the years 2013 and 2014, 5.2% of surveyed businesses failed as a result of inadequate cash flow or sales. Many of them probably did not even realize the magnitude of their financial problems because they were not able to calculate and interpret their financial ratios. This kind of “incompetence” is the reason nearly half (46%) of businesses fail.

Three Categories of Financial Ratios

  1. Growth Ratios
    Growth rates indicate how quickly a company is growing. This includes:

    • Sales — Sales, also called operating revenues are stated in terms of the percentage of growth since the previous year.
    • Dividends — Dividends are a good indicator of the financial stability of a company. The percentage of change in dividends should never be negative. These excess profits are often reinvested back into the company to increase the rate of growth.
    • Net Income — Net income determines how much money is left over after subtracting operating costs.
  2. Price Ratios
    Price ratios establish a stock’s selling price in the context of the company’s profitability. This includes:

    • Price/Earnings Ratio — This is the stock’s current price divided by the most recent 12 months earnings per share; it indicates a projection of future growth.
    • Price/Sales Ratio — This is the stock’s current price divided by the most recent 12 months of sales.
  3. Business Profitability Ratios
    Profitability ratios, also called profitability margins, measure a company’s operating efficiency and generally look at the business within the context of its industry. This includes:

    • Net Profit Margin — This is the ratio of net profits to sales and is one of the best indicators of efficiency because it includes all of the company’s expenses.
    • Gross Margin — This is a ratio of operating revenues to sales.

25% of businesses fail after their first year. If you don’t have a good grip on your financial standing, you are bound to encounter a number of obstacles that you are simply not equipped to overcome. Understanding financial ratios isn’t easy. For the business owner who may not be the most financially “literate,” or for those who just don’t have time to go through all the proper procedures, purchasing financial data analysis software is key.