Financial ratios are metrics that give you information about the performance of various areas of a business’s operations and its financial health. You can find the data needed to construct these indicators from a company’s financial statements.
Business owners and analysts conduct a financial ratio analysis by comparing a company's financial metrics with industry averages. They look to identify non-performing areas where the company is performing worse than the industry averages in order to improve a business’s performance.
Think of financial ratios as the gauges on the dashboard of your car. They tell you which parts of your business are performing correctly and which parts have problems and need your attention.
Typically, the objective of a business is to make a reasonable profit. The profitability ratios show how well a company is meeting this objective.
- Gross profit margin: This an indicator of the profit a company makes from producing a manufactured product or providing a service before deductions for general and administrative expenses, interest and taxes. It is a measure of the company's efficiency in producing a product or service. A gross profit margin must be high enough to pay fixed overhead expenses and leave a reasonable net profit margin. It is calculated as a percentage by deducting the cost of direct labor and direct materials expenses from net sales and dividing by net sales.
- Net profit margin: This is the percentage of profit that remains after deducting the total costs of operation, including interest and taxes, from the company's total sales. You can compare a company’s net profit percentage to industry averages and determine if the company is doing better or worse than its competition.
- Net income: This is the dollar amount of profit left after deducting all the costs of operation from total sales.
- P/E ratio: This is also known as the earnings ratio and is used by companies with publicly traded stock to measure the company’s earnings per share in relation to its stock price. For example, a company with $2 in earnings per share and a current stock price of $30 would have a P/E ratio of 15 ($30 divided by $2). Companies with high growth rates, like high-tech businesses, will have high P/E ratios. More stable companies, such as utilities, will have low P/E ratios. Publicly traded companies with high P/E ratios are also likely to have high beta coefficients. This means that movements in the company's stock price are more volatile compared to changes in the overall stock market.
- Return on equity: This is a measure of the return a company is making on its equity investment. A high ROE shows that a company's management is doing a good job of utilizing its assets to produce a good return.
- Dividend ratio: Some companies provide a steady income to investors by paying dividends. For example, if a company pays an annual dividend of $2 and its current stock price is $50, the dividend return would be 5 percent ($2 divided by $50 times 100).
Read More: Importance of Financial Ratios
Liquidity ratios are indicators of a company's ability to meet its accounts payable, short-term debt and other current liabilities on time.
- Current ratio: This is the company's current or liquid assets – which include cash, accounts receivable and inventory – divided by its current liabilities. A ratio of $2 in current assets for each $1 in current liabilities is considered a comfortable level. A ratio less than 1.5 to 1 could indicate that a company might be having problems meeting its debt obligations.
- Acid test ratio: This is a stricter measure of liquidity than the current ratio. The acid test ratio is calculated by adding cash and accounts receivable and dividing by total current liabilities. This ratio needs to be at least 1:1.
- Working capital: This is a dollar amount found by subtracting total current liabilities from total current assets. As an illustration, if a company has $400,000 in current assets and $200,000 in current liabilities, its working capital would be $200,000 ($400,000 less $200,000). If a company is making a profit, its working capital should be constantly increasing.
Read More: Accounts Receivable vs. Revenue Ratio
Efficiency ratios, also known as asset turnover ratios, measure how well a company uses its assets to generate income, specifically inventory and accounts receivable.
- Inventory turnover ratio: This is a measure of how efficiently a company manages its production, storage and product distribution. Higher turnover ratios are generally indicators of better management. However, extremely high inventory turnover rates could be an indication of inadequate inventory levels and the possibility of lost sales from being out of stock. Conversely, low inventory turnover could be the result of overstocking or large quantities of obsolete items still sitting in the warehouse. In these situations, the value of the inventory might need to be considered to determine if products should be sold at reduced prices to get them off the floor.
- Accounts receivable turnover: For businesses that sell to their customers on credit terms, accounts receivable turnover measures how quickly a company can turn credit sales into cash. Higher receivables turnover rates are better because this means customers are paying more quickly and in accordance with the credit terms. Lower receivables turnover indicates customers are paying more slowly and collection efforts need to be increased before the accounts become uncollectible and must be written off.
Read More: Difference Between Sales Revenue and Gross Profit
Leverage ratios measure the amount of debt a company has on its balance sheet in comparison to its equity capital. Companies with more debt than equity are considered riskier because of their higher leverage. Economic downturns are more likely to affect their solvency compared to companies that are more highly capitalized with larger amounts of equity and are better able to withstand recessions.
On the other hand, highly leveraged companies have the potential to generate higher returns on their equity capital.
- Debt-to-equity ratio: Generally, a good debt-to-equity ratio is considered as no more than $1 in debt for each $1 in equity. Companies that have higher amounts of fixed assets, like electric utilities, will have higher debt-to-equity ratios. Most small businesses will have leverage ratios that range from 1.5 to 2.
- Interest coverage ratio: Businesses with higher amounts of debt will have higher loan payments of principal and interest. A company's earnings multiple (stock price divided by earnings per share) must be sufficient, usually two to three times, to cover these payments. An interest coverage ratio less than one to one means the company does not have enough money to at least meet its interest payments.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.