Like the instruments in the dashboard of your car, financial ratios are metrics that show the health and performance of your business. Monitoring these metrics and conducting a financial ratio analysis gives management an important tool to identify problems, solve them and move the company forward.
What are Financial Ratios?
Financial ratios are metrics that show the relationships between 2 or more line items on your company’s financial statements. They can be expressed as fractions, percentages and as a number of times.
A simple example is the net profit margin, which is net profits divided by total sales. Another example is the current ratio, which is current assets divided by current liabilities.
Types of Financial Ratios
Financial ratios fall into 4 groups:
Gross profit: Found by subtracting cost of goods sold from total sales
Earnings Before Interest and Taxes (EBIT): This is profits after deducting operating expenses and the cost of goods sold (COGS) but before deductions for interest on debt and tax payments
Return on Capital: Net income minus dividends is divided by debt plus total shareholders’ equity. This is usually expressed as a percentage
Quick Ratio: The quick ratio, also known as acid test, measures how well a company can pay its bills using only cash, current accounts receivable and short-term securities
Times Interest Earned: Shows the number of times income exceeds interest payment on debt
Asset Utilization Efficiency
Accounts Receivable Turnover: Total sales divided by the average balance of accounts receivable
Inventory Turnover: Cost of goods sold divided by average inventory balance
Asset Turnover: Total sales divided by total assets
Debt to Equity: Total debt divided by total equity. Indicates the degree of financial leverage
Debt to Total Assets: Total debt divided by total assets. Shows how much of the company’s assets are financed with debt
What Is a Ratio Analysis?
A ratio analysis is the process of using the set of financial ratios prepared from a company’s financial statements to gain insight into its operations. Monitoring these financial ratios over time can chart your company’s overall health. Looking back over several periods will reveal positive or negative trends.
Comparisons of a company’s ratios to industry averages show how the company stacks up against its competitors — including where your company has a competitive advantage and where it needs to improve.
A single number from the financial statements doesn’t mean much by itself. It must be viewed in the context of the entire picture. The true meaning of key ratios emerges only when compared to other figures.
How Ratio Analysis Can Be Useful for Your Business
Performing periodic key ratio analyses will give you a picture of your business’s financial position so you can make the necessary adjustments to improve the company’s financial health.
Watch for negative trends with early warnings of ill health and use them to develop goals to improve areas of weak financial health.
Lenders use financial ratios to determine the health and stability of your business. By looking at your key ratios, you can anticipate the questions a lender is going to ask and be prepared for them.
Take a look at these examples to see how you can use financial ratios to manage your business.
Examples of Ratio Analyses
These examples illustrate the types of analyses and questions posed by financial ratios:
Consider the value of the inventory turnover ratio. The business earns a gross profit with each turnover of inventory, so the more number of turns — selling and restocking products — the better to produce higher gross profit.
A slowdown in turnover could indicate higher levels of obsolete product. This situation would call for reducing prices and selling at discounts to recover cash.
Increasing levels of inventory could signal that prices are rising and buying practices should be examined. Maybe new suppliers are needed to reduce costs and have fewer funds tied up in inventory.
On the other hand, increasing turnovers could signal another type of problem: lost sales. High turnover could mean that inventory levels are too low, and sales are being missed because the products ordered are out of stock.
Having enough cash on hand to pay bills is vital to maintaining good supplier relations and staying in business. The current ratio is a measure of the company’s ability to accomplish this objective by paying expenses on or before due dates.
A good target for this ratio is to maintain $2 in current assets versus $1 in current liabilities. Any ratio less than 2:1 could indicate that the company could begin to have difficulties paying its bills.
Continuing problems with low current ratios could mean that the company needs to solicit more equity capital or to refinance short-term debt into longer-term maturities. Funds could be used to reduce current liabilities and increase the current ratio.
Conversely, a high current ratio may indicate that too much capital is invested in current assets and the fund could be better utilized in other areas, such product development or marketing campaigns into new regions.
Gross Profit Margin
Gross profit margin is an indication of your company’s efficiency at producing its products. It measures the effectiveness of your pricing strategies and the productivity of your operations. You have to maintain gross margins in line with other companies in your industry to remain competitive.
A trend of declining gross margins means it’s time to re-evaluate production processes and costs to find room for improvement.
Financial leverage — utilizing debt to purchase assets — is a two-edged sword. In rising economic times with good profits, high financial leverage will bring an attractive return on shareholders’ capital. However, in economic downturns with declining profits and cash flow, a company could quickly find itself unable to meet its fixed-debt obligations and be driven into bankruptcy.
For most businesses, a comfortable debt-to-equity ratio is to have $1 in debt for each $1 in equity capital. While this amount of leverage will not result in the highest return on capital, it will put the company in a better position to survive economic downturns and still be around to earn profits another day.
As a small business owner, you should constantly keep an eye on your debt-to-equity ratio to gauge the financial risk you are assuming and know when to take on additional debt and when you need to raise more equity capital.
What are the Limitations of Ratio Analysis?
Because a company’s financial statements are used to create the financial ratios, any weaknesses in the data used to prepare the financial statements will affect the validity of the ratios.
Financial ratios are subject to the following limitations:
Inaccurate Accounting Data: Accountants apply relevant accounting policies to the data used to create financial statements. The soundness of this practice depends on the competence and judgment of those who are making these decisions.
No Consideration of Qualitative Factors: Accounting is only applied to the quantitative factors of business. For example, financial ratios do not measure customer opinions about company brand and culture.
Inability to Solve Problems: Ratios are simply indicators and do not provide solutions.
Doesn’t Consider Price Changes: Inflation changes the value of money, reducing the interpretations of comparisons with previous years.
As a small business owner, you should learn which financial ratios are important for your company and your industry. If you’re a retailer, inventory turnover and gross margins are important. Manufacturers are concerned about levels of inventory and collecting receivables, and contractors are paying attention to equipment maintenance cost and labor productivity.
These ratios are the dashboard instruments for your company. Follow them and use their messages to improve your business.