Financial ratios give you insights on the business that an Income Statement or a Balance Sheet alone cannot provide. They allow you to evaluate the company’s performance and compare it to other similar businesses in the industry. Financial ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This allows you to follow your company’s performance over time and uncover signs of trouble.
Here are some key financial ratios to measure the financial health of your business:
Leverage ratios
Debt-to-equity ratio = Total liabilities / Shareholders’ equity
Measures how much debt a business is carrying as compared to the amount invested by the business owners. This indicator is closely watched by lenders and investors as a measure of a business’s capacity to repay its debts.
Debt-to-asset ratio = Total liabilities / Total assets
This ratio shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness.
Liquidity ratios
Working capital ratio = Current assets / Current liabilities
Working capital indicates whether a business has sufficient cash flow to meet short-term obligations, take advantage of opportunities and attract favourable credit terms. A ratio of 1 or greater is generally considered acceptable for most businesses.
Cash ratio = Liquid assets / Current liabilities
Indicates a company’s ability to pay immediate creditor demands, using its most liquid assets. It gives a snapshot of a business’s ability to repay current obligations as it excludes inventory and prepaid items for which cash cannot be obtained immediately.
Profitability ratios
Net profit margin = After tax net profit / Revenue
This financial ratio shows the net income generated by each dollar of revenue. It measures the percentage of sales revenue retained by the company after operating expenses, interest and taxes have been paid.
Return on equity = Net income / Shareholders’ equity
Indicates the amount of after-tax profit generated for each dollar of equity. A measure of the rate of return the shareholders received on their investment.
Coverage ratio = Profit before interest and taxes / Annual interest charges
Measures a business’s capacity to generate adequate income to repay interest on its debt.
Return on total assets = Income from operations / Average total assets
This ratio measures the efficiency of assets in generating profit.
Operation ratios
Accounts receivable turnover = Net sales / Average accounts receivable
A higher turnover rate generally indicates less money is tied up in accounts receivable because customers are paying quickly.
Average collection period = Days in the period X Average accounts receivable / Credit sales
Indicates the amount of time customers are taking to pay their bills.
Average days payable = Days in the period X Average accounts payable / Purchases on credit
Measures the average number of days it you are taking to pay suppliers.
Inventory turnover = Cost of goods sold / Average inventory
This ratio indicates the number of times inventory has been turned over during the year.