A financial ratio measures the relationship between two or more components on the company’s financial statements. These ratios provide a quick and easy way to track performance, benchmark with those in the industry, identify trouble spots and proactively implement solutions.
Why is measuring financial ratios important?
Ratios allow business owners to benchmark the company against competition and, more generally, against others in their sector. They allow a business to benchmark its performance and identify targets for improvement. They enable companies to see where things are going wrong and introduce measures to either avoid or alleviate potential problems. Suppose the business is seeking funding from an external source, such as a bank or investor. In that case, the financial ratios will provide those stakeholders with the information required to see if the business can pay the money back and generate a good return on investment.
How often to monitor ratios
It is important for small businesses to regularly monitor financial ratios. The frequency of monitoring will vary depending on the particular ratio and the nature of the business, but a general guideline is:
- Monthly: Liquidity and Efficiency Ratios
- Quarterly: Profitability and Solvency Ratios
- Annually: Detailed analysis of all ratios
The data used in computing these ratios usually come from the income statement.
Gross profit margin:
Higher gross profit margins indicate that the firm efficiently converts its product (or service) to profits. The cost of goods sold includes the amount incurred to produce a product and represents the summation of material and labor costs. Net sales are defined as revenueless returns, discounts, and sales allowances.
| Gross profit margin = net sales – cost of goods or services sold/net sales X 100 |
Net profit margin:
A higher net profit margin shows the corporation does good business, translating sales to profit. Identify peer companies for comparing success because those margins vary across each industry.
| Net profit margin = net profit/sales X 100 |
Operating profit margin:
A profitability measure that shows how efficiently a company can produce from its revenue an operating profit. Increasing operating margins can denote improved management and cost controls of a company.
| Operating profit margin = gross profit – operating expenses/revenue X 100 |
Gross profit less operating expenses is also equal to earnings before interest and taxes, EBIT.
Return on equity:
This measures the rate of return shareholders get on their investments after taxes.
| Return on equity = net profit/shareholder’s equity |
Working capital or current ratio:
Can the business meet its short-term obligations? The current ratio is an indicator of a company’s ability to meet its short-term obligations with its short-term assets. A ratio greater than 1 demonstrates that a company has sufficient liquidity while one lower than 1 indicates a probable liquidity issue. A ratio of 1 or higher means the value of a firm’s assets exceeds the liabilities the firm owes. The current ratio is sometimes called the working capital ratio.
| Working capital ratio = current assets/current liabilities |
Cash Ratio
A liquidity ratio measures the company’s ability to pay off its short-term liabilities with the use of cash and cash equivalents. A higher ratio is indicative of greater liquidity to a certain extent but might also imply inefficiency when it comes to using cash. This measure is very similar to the working capital ratio but only takes into account cash and cash equivalents. In other words, inventory will not be included in this calculation.
| Cash ratio = cash and cash equivalents/current liabilities |
Cash equivalents are those investments that mature in 90 days. This can consist of some short-term bonds and treasury bills.
Quick ratio
The Quick Ratio is sometimes referred to as the acid-test ratio, measuring a firm’s capability of meeting its short-term liabilities with its most liquid assets. Since inventory takes a longer time to convert into cash, the quick ratio thus comes up with a stricter inference of the liquidity of the company compared to that of the current ratio. Like the cash ratio, it takes into account the asset that can easily be liquidated into cash.
| Quick ratio = current assets – inventory – prepaid expenses / current liabilities |
Cash flow to debt ratio:
How much of the business’ debt could be paid with operating cash flow? Cash flow is a solvency ratio used to assess a company’s ability to settle its total debt from operating cash flow. The formula for this ratio is Operating Cash Flow ÷ Total Debt. A larger ratio denotes improved repayment capacities, while a smaller one indicates a considerable risk.
For example, if the ratio is 2, then for each dollar of liability, the company earns two dollars. In other words, the company can cover twice as much of its liability.
| Cash flow to debt ratio = operating cash flow/debt |
There are a couple of 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:
It measures the amount of cash the business generates relative to sales. This figure should remain steady as sales rise, according to Accounting Tools. If it is decreasing, this may be a sign of imminent cash flow problems.
| Operating cash flow to net sales ratio = operating cash flow/net sales |
Free cash flow to operating cash flow ratio:
This ratio shows the proportion of operating cash flow that is remaining after capital expenditures and thus represents financial flexibility for the organization. The greater the ratio, the more money that is left to be used for expansion, repaying debt, and returning capital to shareholders. In general, investors will favor a high free cash flow. And the higher the ratio here, the better the indication 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
Revenue per employee:
How productive and efficient 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:
It measures how efficiently the assets are generating profit.
| Return on total assets = net income/average total assets |
Calculate average total assets by adding all the assets at the end of the year plus all the assets at the end of the prior year and dividing that by 2.
Inventory turnover:
It measures how well the company sells its inventory. Start with average inventory by taking the inventory balance from a specific quarter, let’s say one quarter and add it to the previous quarter’s inventory balance. Divide that by two for the average inventory.
| Inventory turnover = cost of goods sold/average inventory |
Accounts receivable turnover:
It measures how effectively a firm is managing collections. A higher rate normally indicates that customers are paying quickly. You will 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 a sense of how long it takes for customers to pay their bills. Here is the formula for calculating the average collection period for a given year.
| Average collection=365 × accounts receivable turnover ratio / net credit sales |
Use the following formula to compute net credit sales:
| Net credit sales = Credit sales – Sales returns – Sales allowance |
Days payable outstanding (DPO):
The average number of days the company takes to pay creditors and suppliers. This ratio will help the business realize how well it manages cash flow. To find DPO, start with the average accounts payable for a given time; this could be a month, quarter, or year:
| Average accounts payable = beginning balance of accounts payable/2 by the end of the period 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:
It calculates how long, on average, it takes 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 |
Debt to equity ratio:
Indicator of a company’s ability to service loans.
| Debt to equity ratio = total liabilities/shareholder’s equity |
Debt to asset ratio:
It generates a sense of how much the firm is financing its assets. An increasing debt-to-asset ratio would, therefore, signal financial distress.
| Debt to asset ratio = total liabilities/total assets |
Such financial ratios give convenient and informative data handy for potential financiers and investors. The ratios are a way through which startups present the investors with an assurance that the business is good financially. These ratios are relative specifically to accounts receivable and are of special significance for small business borrowing lenders. The ratios are a way for startups to show investors that the business is financially solid. The ratios related to accounts receivable are especially important for small businesses seeking loans. The cross-sectional financial ratios are not for the purpose of raising funds only.
They may be applied to give key performance indicators and contribute to strategic decision-making to fulfill organizational objectives. For instance, when a firm uses ratio analysis to compare inventory turnover against industry standards, a company achieves the right balance of having too much cash invested in inventory or too little inventory to meet customer needs. In other words, all of the information reported in the current study will be sourced from a company’s financial statements. Applying the technology to automate the accounting process of preparing static financial statements used less time and eliminated the human mistakes that could be made. To work using small business accounting software you get significantly more accurate and comprehensive information on financials and the process of calculating the financial ratios becomes quicker and easier because the business is financially solid. The ratios related to accounts receivable are especially important for small businesses seeking loans.
Financial ratios exist for functions beyond funding acquisition. Business KPIs and strategic guidance to achieve business objectives result from ratio implementation. When analyzing inventory turnover against industrial benchmarks organizations can optimize inventory stock levels to maintain appropriate levels of cash and meet customer requirements effectively. Companies obtain all necessary data for their financial ratios from their standard financial statements. Technology-based automation of accounting functions generates static financial reports while reducing both processing time and human mistakes. The accurate and complete data provided by small business accounting software streamlines financial ratio calculation and enhances your ability to receive robust financial information. Learning the actual significance of ratios stands as the main requirement before proceeding. Automated financial ratio calculation gives you superior insight into the firm’s financial standing by providing exact point-in-time pictures. This method produces direct information that simply represents the actual company financial status.
