Understanding financial ratios is a key business skill for any business owner or entrepreneur. Financial ratios illustrate the strengths and weaknesses of a business. By examining ratios over time, a business owner can notice any unusual fluctuations in financial ratios and can note how the business is performing over time. Ratios are also helpful tools in financial analysis and forecasting; ratios allow entrepreneurs to set specific goals and to easily track progress toward those goals.
It is important to choose financial ratios that are applicable to the business at hand. There are hundreds of financial ratios available, some of which apply to all businesses and some of which are industry-specific. Below are explanations of some of the most common financial ratios.
Operating Margin = Operating Income / Net Sales
This ratio shows how much of a company’s revenue is left after paying off all operating expenses, such as employee salaries and raw material costs. A low operating margin is a sign that a business might not have enough revenue to pay off debt and other non-operating costs.
Gross Margin = (Revenue – Cost of Goods Sold) / Revenue
Gross margin is a representation of how much revenue remains after a company pays all of the direct costs associated with generating that revenue. The higher this ratio is, the more revenue the company has to pay off other expenses.
ROE (Return on Equity) = Net Income / Shareholder’s Equity.
This ratio measures how much profit the shareholder’s investment has generated. A higher ROE percentage indicates that shareholders are receiving a better return on their investment.
ROA (Return on Assets) = Net Income / Total Assets.
This ratio measures how profitable a company is relative to its total assets. A high ROA indicates that management is effectively utilizing the company’s assets to generate profit.
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The quick ratio measures the liquidity of a company. The higher this ratio, the more liquid assets a company has to meet immediate financial obligations.
Current Ratio = (Current Assets / Current Liabilities)
The current ratio is another measure of liquidity. The current ratio is a bit more forward-looking than the quick ratio; unlike the quick ratio, the current ratio includes inventories in current assets, because inventories can be sold over a short period of time to generate cash.
ISCR (Interest-Service Coverage Ratio) = Net Operating Income / Interest Expense
ISCR indicates how much cash a company has to pay interest on its debt. A high ISCR ratio means that a company is well-prepared to pay its upcoming interest expenses.
DSCR (Debt-Service Coverage Ratio) = Net Operating Income / Total Debt Service
DSCR measures the cash available to meet debt payments, including principal and interest payments. In some cases, Operating Cash Flow is substituted for Net Operating Income in the formula. A high DSCR ratio indicates that a company has enough cash flow to cover debt obligations.
Debt to Equity Ratio = (Total Liabilities / Shareholder’s Equity)
This ratio indicates how levered a company is. A high debt to equity ratio illustrates that a company is highly levered, or that it carries a lot of debt relative to shareholder’s equity. The appropriate debt to equity ratio depends on a company’s industry and financial health.
Receivables Collection Period = (Days x Accounts Receivable) / Credit Sales.
This ratio provides the average number of days that it takes for a company to receive payments from customers. A lower number of days receivable indicates that a company is efficiently managing its accounts receivable process.
Days Payable Outstanding = Accounts Payable / Cost of Sales x Number of Days
This ratio indicates how long a company takes to pay suppliers and vendors. The optimum number of days payable varies by company and by industry. Each company wants to have flexible payment terms to allow liquidity but does not want to incur past-due invoices and fees.
Inventory Turnover = 365 / (Cost of Goods Sold / Average Inventory)
This ratio shows how many days inventory a company has on hand. A high inventory turnover indicates excess inventory and perhaps low sales. A low ratio might indicate strong sales or the need to increase inventory levels.
Using these ratios is the first step to taking a deep look into the financials of a business. Also, ratios may help you to justify decisions when you are buying or selling a business. These figures can illuminate unforeseen problems in a company and can highlight unexpected successes. Adding financial ratios into the financial planning process can be an invaluable tool to improving business performance.