Key Financial Ratios Help Manage Your Business
Your attention is usually focused on a key area within your company. Maybe that’s in marketing, sales or technology. Handling the financials may not be your forte. But, it’s important to be able to analyze your company using business profitability ratios.
Financial ratios are used as indicators that allow you to zero in on areas of your business that may need attention, such as liquidity, profitability, operational efficiency, and solvency. Financial ratios are also useful tools in forecasting and financial analysis. They allow you to set specific goals and track your business’s progress toward these goals.
It’s important to choose financial ratios that apply to your business. There are hundreds of financial ratios out there and while some of them apply to all businesses – there are some specific financial ratios by industry.
Here are the top five most powerful and widely known financial ratios you should use in order to make your business succeed:
1. Net Profit Margin
This ratio is the most important measurement. With this ratio, you can understand how each dollar earned by your company is translated into profits.
How to Compute Profit Margin Ratio:
Net Profit / Net Sales
It indicates how efficient your company is at its cost control. For example, a higher Net Profit Margin means the business converts its revenue into actual profit more effectively.
You can use this ratio to compare yourself to your industry peers, as well.
2. Current Ratio
This ratio is a performance measurement of a company’s liquidity. The measurement determines if your business has enough resources to pay its debts over the next year. It includes your company’s cash amount and inventory.
How to calculate the Current Ratio:
Current Assets / Current Liabilities
Financial lenders who need to decide whether to give the business a short-term loan use this ratio. But, it can also be used to view a snapshot of the efficiency of the company’s operating cycle or how well it can turn its product into cash.
3. Debt-to-Equity Ratio (D/E)
The Debt-to-Equity Ratio, also known as financial leverage, determines the relative proportion of a business’s equity and debt used to finance its assets. It’s a very important ratio as it’s used as a standard for determining a business’s financial performance and whether it’s financially healthy.
How to calculate the D/E Ratio:
Total Liabilities / Shareholders Equity
The D/E ratio also shows the company’s ability to repay debts. Lenders prefer low D/E ratios. So, if the ratio is increasing, this means that your business is not being financed on its own, but instead by creditors – which could be a bad sign to financial lending institutions.
4. Quick Ratio
The Quick Ratio, sometimes referred to as the Quick Assets Ratio or “acid test,” provides you a short-term view of the company’s cash situation or liquidity in relation to its short-term debts so you can determine whether a business can meet its financial obligations if issues arise.
How to calculate the Quick Ratio:
(Current Assets – Inventories)/ Current Liabilities
You are looking for a higher quick ratio here.
5. Return on Equity (ROE) Ratio
The ROE ratio, or Return on Net Worth (RONW), is one of the most important profitability metrics. It shows you how much profit a business earned compared to the total amount of shareholder equity found on the balance sheet.
In other words, it measures how profitable a business is for the investor and how profitably it utilizes equity. Note: this ratio is expressed as a percentage.
How to calculate ROE:
Net Income/Shareholder’s Equity
Financial ratios can be complex, but just by simply converting all of this raw data, which can be found on financial statements, into information you need helps make your business a success! And, luckily for you – there is a simpler way to compute most of these complex financial ratios by using IndustriusCFO’s products that include ratio calculators. Use our financial analysis suite and start building a better, more profitable business.
Pinpoint that one difference maker that has been eluding you. Know what portions of your business need attention and adjustments to help you grow and be more profitable. Generate a quick snapshot of your business’s health and a game plan to begin making improvements today. IndustriusCFO’s ratio calculators can compute these standard, common ratios:
- Quick Ratio
- Current Ratio
- Current Liabilities to Net Worth – this is the measure of the extent to which the enterprise is using creditor funds vs. their own investment to finance the business.
How to Calculate Current Liabilities to Net Worth:
Current Liabilities/Liabilities + Equity
You don’t want to see a ratio of .5 or higher because that would indicate inadequate owner investment or an extended accounts payable period.
- Current Liabilities to Inventory – this ratio offers an indication of the ability of your firm’s inventory sales to generate cash needed to meet the short-term obligation of creditors. Look for the result of a low ratio, which means that your company will be able to meet short-term obligations. A high ratio may be cause for concern since it may signal a potential cash shortage.
How to Calculate Current Liabilities to Inventory:
Current Liabilities x 100/Available Inventory
- Total Liabilities to Net Worth – this ratio reveals the relation between the total debts and the owners’ equity of a company. You want to see a higher ratio here, which indicates less protection for business’ creditors.
How to Calculate Total Liabilities to Net Worth:
Total Liabilities/Liabilities + Equity
- Fixed Assets to Net Worth – The Center for Business Planning says this is the measure of the extent of an enterprise’s investment in non-liquid and often over valued fixed assets.You don’t want to see the result of .75 or higher because this indicates possible over-investment and causes a large annual depreciation charge that will be subtracted from the income statement.
How to Calculate Fixed Assets to Net Worth:
Fixed assets to Net Worth=Net fixed assets/Net Worth
- Interest Coverage – this ratio is used to determine how easily your business can pay interest on outstanding debt.
How to Calculate Interest Coverage:
- Cash Conversion Cycle (measured in days) – this ratio measures how fast your business can convert cash on hand into even more cash on hand.
How to Calculate Cash Conversion Cycle:
Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding
- Return on Sales – this ratio is also known as a firm’s operating profit margin and is widely used to evaluate a business’s operational efficiency. This ratio provides insight into how much profit is being produced per dollar of sales. The ratio is helpful to management.
How to calculate this profitability ratio:
Net Income (Before Interest and Tax)/Sales
- Return on Assets – Also known as Return on Investment, this ratio is an indicator of how much profitable a company is relative to its total assets. It gives you an idea as to how well your company is using its assets to produce earnings.
How to calculate Return on Assets:
Net Income/Total Assets
It’s also important to note that when performing this calculation, some investors add interest expense back into net income because they want to use operating returns before cost of borrowing.
- Sales per Employee or Revenue per Employee – this ratio will help you examine your business’s sales in relation to its number of employees. It’s most useful when you compare your results to your industry peers.
How to calculate Sales per Employee:
Revenue/# of employees
You want to see the highest revenue possible per employee possible because this means there’s higher productivity.
- Profit per Employee – Mark Staniszewski, IndustriusCFO account manager says, “This is a measure of the profits your firm is generating for each employee working for you. The management of labor resources is important to the success of your business and you should carefully compare both sales and profits per employee for your firm with similar firms in your industry.”
How to calculate Profit per Employee:
Net Profit/Number of Employees
- Asset Investment to Sales – this ratio measures a company’s efficiency in managing its assets in relation to the revenue created. The higher this ratio, the smaller the investment required to produce sales revenue, thus, higher the profitability of the company.
The formula to calculate Asset Investment to Sales:
Sales Revenue/Total Assets
- Gross Margin – this ratio is also known as the gross profit margin or gross profit percentage. You should be continuously monitoring your company’s gross margin ratio to make sure it will result in a gross profit that will be enough to cover its selling and administrative costs.
How to compute Gross Margin:
Gross Profit Dollars/Net Sales Dollars
Since gross margin ratios vary between industries, you should compare your company’s gross margin ratio to your industry peers.
IndustriusCFO also computes asset efficiency ratios that are measured in days including Collection Period, Payment Deferral Period, Inventory Turnover, and Age of Inventory. These asset efficiency ratios are not measured in days: Assets to Sales, Sales to Working Capital, and Accounts Payable to Sales.
Other ratios we compute include Book Value to Total Assets (Valuation Ratio), Debt to Equity Ratio (Leverage Ratio), Growth Rate (Growth Ratio), and Sustainable Growth Rate (Growth Ratio).
Financial Ratios Related to Financial Statements
A traditional way to convey relationships between one aspect of the Income Statement to another, is by way of percentage. Given the nature of how these percentages are calculated, they can certainly be qualified as ratios and provide meaningful information for comparing your business’s performance against past operating periods, or comparison to industry peers.
To illustrate how these ratios can provide impactful information for your business, let’s assume your business has $1,000,000 in Net Sales. The business’s Overhead is $100,000. You’ll want to display this as a percentage, which allows you to easily compare your results to your business’s past performance and against industry peers.
Considering the above example, the calculation would be $100,000/$1,000,000. Overhead is “10%” of Net Sales. Say, last year, your business’s overhead was 15% of Net Sales, or Industry Peer trends show Overhead at 12% of Net Sales. As you can see, it’s far easier to compare your results as a percentage rather than less-than-comparable USD ($) figures.
Income Statement analyses include such financial ratios when displayed in percentage, by showing the relationship of each Income Statement account as a % of Net Sales:
- Cost of Sales OR Cost of Goods Sold (Service company vs. Manufacturing)
- Material Cost
- Labor Cost
- Gross Profit Margin (already above)
- Operating Expenses
- Bad Debt
- Other Operating Expenses
- EBITDA (earnings before interest, tax, depreciation & amortization)
- Depreciation & Amortization
- EBIT (earnings before interest and taxes, otherwise known as “Operating Profit”)
- Interest Expense
- Other Expense
- Income Taxes
- Net Income
The accounts associated with the Assets side of the Balance Sheet are traditionally shown as a % of Total Assets, and include:
- Total Current Assets
- Accounts Receivable
- Prepaid Expenses
- Other Current Assets
- Total Non-Current Assets
- Fixed Assets
- Intangible Assets
- Long-Term Investments
- Other Non-Current Assets
The accounts associated with the Liabilities & Net Worth side of the Balance Sheet are traditionally shown as a % of Total Liabilities and include the following:
- Total Current Liabilities
- Accounts Payable
- Short-Term Notes Payable
- Bank Loan Payable
- Current Maturities of Long-Term Debt
- Other Current Liabilities
- Total Long-Term Liabilities
- Long-Term Notes Payable
- Other Non-Current Liabilities
- Net Worth
IndustriusCFO’s Financial Ratio Analysis Expands on Traditional Ratios
- Net Balance Position (NBP), and NBP Ratio – traditional Liquidity ratios, like the Quick and Current Ratio tend to cluster aspects of the Balance Sheet and thus, some Liquidity and Asset Efficiency issues may remain hidden. For example, imagine two companies, one having $100K in Cash, $400K in Accounts Receivable (AR), the other having $250K in Cash and $250K in AR.
If all else were equal between the two companies, the Quick and Current Ratios would view them as performing equally, because they both have $500K in Current Assets. However, one company has far better efficiency in AR collection, with much more Cash on hand. This deeper assessment is made possible, by a proprietary measure developed to tease apart aspects of the Balance Sheet and provide a more stringent measure of Cash Liquidity. If your NBP is zero or positive, your company is in a decent liquidity position.
How to calculate Net Balance Position:
Operating Capital Available – Operating Capital Required = NBP
- Return on Asset Investment – this is a returns ratio that will allow you to calculate how efficiently your company is using their total asset base to generate sales. The reason that the return on assets ratio is also known as the return on investment ratio is because investment refers to a firm’s investment in its assets.
How to calculate Return on Asset Investment:
Return on Assets = Net Income (Net Profit)/Total Assets= __%
Understanding financial ratios is a key business skill for any entrepreneur or business owner. To summarize what we’ve discussed in this guide to financial ratio analysis, financial ratios illustrate the strengths and weaknesses of your business. By analyzing these ratios over time, you have the ability to notice any unusual fluctuations in financial performance across different operating periods, and when compared to industry peers or competitors.