16 Aug Financial Ratios Primer

Understanding the financial health of a company is essential for investors, analysts, and stakeholders. Financial ratios provide a powerful tool to assess a company’s performance, profitability, liquidity, and overall stability. In this article we will delve into the key financial ratios that play a crucial role in evaluating a company’s financial standing.

For startups specifically, these ratios play a crucial role in showcasing the robustness of their business model. Among these ratios, those tied to accounts receivable assume a large role, particularly for small businesses eyeing loans. A report by Funding Circle, a peer-to-peer lending marketplace, highlights that banks often assess eligible receivables at 70%–80% of their value for asset-backed loans.

Yet, financial ratios are not confined to the realm of securing funds; they serve as strategic compasses steering companies toward their goals. Consider the example of inventory turnover. By calculating and comparing this ratio against industry benchmarks, a company can strike an optimal balance between efficient cash flow management and meeting customer demand.

Research conducted by the Federal Reserve Bank of Chicago underscores the direct link between financial management practices and the overall health of small businesses. The frequency of financial analysis plays a pivotal role in this equation. The U.S. Small Business Administration reveals that businesses analyzing their financial numbers annually may have a success rate as low as 25%. However, those engaging in monthly or weekly analyses see their success rates soar to 75–85% and an impressive 95% respectively.

Ratios that help determine profitability

The data used to calculate these ratios are usually on the income statement.

Gross profit margin:

Higher gross profit margins indicate the company is efficiently converting its product (or service) into profits. The cost of goods sold is the total amount to produce a product, including materials and labor. Net sales is revenue minus returns, discounts and sales allowances.

Gross profit margin = (revenue – cost of goods or services sold)/revenue X 100

Net profit margin:

Higher net profit margins show that the company is efficiently converting sales into profit. Look at similar companies to benchmark success as net profit margins will vary by industry.

Net profit margin = net profit/sales X 100

Operating profit margin:

Increasing operating margins can indicate better management and cost controls within a company.

Operating profit margin = (gross profit – operating expenses)/revenue X 100

Gross profit minus operating expenses is also known as earnings before interest and taxes (EBIT).

Return on equity:

This measures the rate of return shareholders get on their investment after taxes.

Return on equity = net profit/shareholder’s equity

Ratios that measure liquidity

These metrics measure how fast a company can pay back its short-term debts. Use information from the balance sheet and the cash flow statement for these ratios.

Working capital or current ratio:

Can the business meet short-term obligations? A working capital ratio of 1 or higher means the business’ assets exceed the value of its liabilities. The working capital ratio is also known as the current ratio.

Working capital ratio = current assets/current liabilities

Cash ratio:

This measure is similar to the working capital ratio, but only takes cash and cash equivalents into account. This will not include inventory.

Cash ratio = cash and cash equivalents/current liabilities

Cash equivalents are investments that mature within 90 days, such as some short-term bonds and treasury bills.

Quick ratio:

Similar to the cash ratio, but also takes into account assets that can be converted quickly into cash.

Quick ratio = (current assets – inventory – prepaid expenses)/current liabilities

Cash flow to debt ratio:

Measures how much of the business’ debt could be paid with the operating cash flow. For example, if this ratio is 2, the company earns $2 for every dollar of liabilities that it can cover. Another way of looking at it is that the business can cover its liabilities twice over.

Cash flow to debt ratio = operating cash flow/debt

There are a couple ways to calculate the operating cash flow. One is to subtract operating expenses from total revenue. This is known as the direct method.

Operating cash flow to net sales ratio:

Measures how much cash the business generates relative to sales. Accounting Tools says this number should stay the same as sales increase. If it’s declining, it could be a sign of cash flow problems.

Operating cash flow to net sales ratio = operating cash flow/net sales

Free cash flow to operating cash flow ratio:

Investors usually like to see high free cash flow. And a higher ratio here is a good indicator of financial health.

Free cash flow = cash from operations — capital expenditures

Free cash flow to operating cash flow ratio = free cash flow/operating cash flow

Ratios that measure operational efficiency

These ratios point to the company’s core business activities. They’re calculated using information found on the balance sheet and income statement.

Revenue per employee:

How efficient and productive are employees? This ratio is a good way to see how efficiently a business manages its workforce and should be benchmarked against similar businesses.

Revenue per employee = annual revenue/average number of employees in the same year

Return on total assets:

Looks at the efficiency of assets in generating a profit.

Return on total assets = net income/average total assets

Calculate average total assets by adding up all assets at the end of the year plus all the assets at the end of the prior year and divide that by 2.

Inventory turnover:

Examines how efficiently the company sells inventory. Start with the average inventory by taking the inventory balance from a specific period (a quarter, for example) and add it to the prior quarter inventory balance. Divide that by two for the average inventory.

Inventory turnover = cost of goods sold/average inventory

Accounts receivable turnover:

Measures how well a company is managing collections. A higher rate usually means customers are paying quickly. You’ll need to know the average accounts receivable. To calculate that, take the sum of starting and ending receivables over a period and divide by two. This period can be a month, a quarter or a year.

Accounts receivable turnover = net annual credit sales/average accounts receivable

Average collection:

This is a related measure to give a business the sense of how long it takes for customers to pay their bills. Here’s the formula to calculate the average collection period for a given year.

Average collection = 365 X accounts receivable turnover ratio/net credit sales

To calculate net credit sales, use this formula:

Net credit sales = sales on credit — sales returns — sales allowances

Days payable outstanding (DPO):

The average number of days it takes the company to make payments to creditors and suppliers. This ratio helps the business see how well it’s managing cash flow. To calculate DPO, start with the average accounts payable for a given time (could be a month, quarter or year):

Average accounts payable = (accounts payable balance at beginning of period — ending accounts payable balance)/2

DPO = average accounts payable/cost of goods sold X number of days in the accounting period

The resulting DPO figure is the average number of days it takes for a company to pay its bills.

Days Sales Outstanding:

Shows how long on average it takes for customers to pay a company for goods and services.

Days sales outstanding = accounts receivable for a given period/total credit sales X number of days in the period

Ratios that help determine solvency

These ratios look at a business’ ability to meet long-term liabilities using figures from the balance sheet.

Debt to equity ratio:

An indication of a company’s ability to repay loans.

Debt to equity ratio = total liabilities/shareholder’s equity

Debt to asset ratio:

Gives a sense of how much the company is financing its assets. A high debt to asset ratio could be a sign of financial trouble.

Debt to asset ratio = total liabilities/total assets

Conclusion

Financial ratios serve as valuable tools to analyze a company’s financial performance, strengths, and weaknesses. By understanding and interpreting these ratios, investors and stakeholders can make informed decisions about investing, lending, and partnering with companies. Remember that while ratios offer insights, they should be considered alongside other relevant factors for a comprehensive assessment of a company’s financial health.