How to Use Financial Ratios to Measure Success

What Are Financial Ratios?

A financial ratio is an analytical number that compares two numbers from the balance sheet, income statement, and cash flow statement of an organization. It can also be known as accounting ratios, financial leverage ratios, and similar names. Financial ratios are beneficial to every individual directly or indirectly involved with the financial statements of an organization. Business ratios express the relationship between the company’s financial accounts. Financial statements of an organization might include many details and numbers, but it is not easy to make sense of the information, though ratios help business owners in making a better analysis of the company’s financial health. Business ratios help in identifying the issues in the financial health of a business, which cannot be easily visible by just looking at the income statements. It should be noted that ratios alone cannot help in deciding the company’s current state. It requires a comparison of the current numbers with the previous numbers of the same. Financial ratios can also be helpful in ensuring that the growth of the business is sustainable and competitive. Businesses can also compare the company’s past performance with the industry standards by using financial ratios. If business managers and owners use ratios that best fit their business, it will help them understand the weak points and improve where they are necessary. So, one should understand what financial ratios are used by companies and what they represent. It will also show how financial ratios can help manage a business more efficiently. Financial ratios are an excellent way to show a clear and concise view of a company’s financial statements. Business owners, investors, and analysts use these ratios to gauge how well a company can fulfill its short-term and long-term obligations. But before that, one should have a good understanding of financial ratios. Let’s begin with understanding financial ratios. 

Liquidity Ratios

Liquidity ratios measure the ability of a company to cover its short-term debt using its short-term assets. As per experts of capital of knowhow.com, “Financial liquidity refers to the ease with which an asset or security can be converted into cash without affecting its market price. So, having a lot of liquid assets means your company can pay its debts as they come due.” 

The primary ratio that is used by many companies is the Current ratio, which is defined as the short-term assets divided by short-term liabilities. A current ratio of 2: 1 or 2 shows that the assets are twice the liabilities and is generally accepted as the standard. This liquidity ratio can also be termed as working capital or acid-test ratios. 

Current Ratio (Net Working Capital Ratio) = Current Assets / Current Liabilities. 

Another widely used liquidity ratio is the Quick ratio or Acid test ratio. Quick ratio is the difference between current assets minus the inventories divided by current liabilities. In other words, it is a calculation that finds out whether the organization’s most liquid assets will be able to cover its current liabilities. A quick ratio of 1: 1 or 1 is generally accepted as the standard. 

Quick Ratio = (Current Assets – Inventories) / Current Liabilities.

Profitability Ratios

Profitability ratios measure the company’s ability to generate profit on its investment in the form of equity and debt over a specific period. Profitability ratios can be very handy for a small business owner and a sole trader because he would want to ensure that the business is growing to become profitable. The following are a few profitability ratios that are used by small business owners and sole traders.a 

Gross Profit Margin = Gross Profit / Sales.  

Gross Profit Margin is a ratio used by a company to find out the total manufacturing and production costs on every sales dollar. It is calculated as the total sales minus the cost of goods sold. 

The gross margin represents the total operating costs that are associated with the production of the goods and the services a company offers. Operating costs do not include the interest, taxes, or any other expenses. 

Net Profit Margin = Net Income / Revenue.  

Net Profit Margin of a company is calculated by the company’s net income divided by the total revenue or sales. This can also be known as net earnings margin or return on sales. It shows what percentage of a dollar of sales will the company will take home as a profit after subtracting all the expenses. 

Return on Assets (ROA) = Net Income / Average Total Assets. 

Return on Assets is defined as the net profit margin divided by the total assets of the company. It shows how good a company is at using its total assets to generate profits. 

Return on Equity (ROE) = Net Income / Shareholder’s Equity. 

Return on Equity ratio is defined as the net income divided by the shareholder’s equity. Return on Equity will help in understanding how good the company is at generating profits on the total money invested in the company by the owners. 

Return on Capital Employed (ROCE) = EBIT / Capital Employed. 

Return on Capital Employed is calculated as the earnings before the interest and tax divided by the capital employed. ROCE is a measure that shows how good the company is at using the invested capital to generate profits.

Leverage Ratios

Leverage ratios are used to measure the company’s capital structure. Leverage is known to be the proportion of a company’s long-term debt to its total assets. The following are a few leverage ratios that are used by many companies. 

Debt to Asset Ratio = Total Debt / Total Assets. 

The ratio that is widely used by many companies is the debt to assets ratio. This is a measurement of what percentage of the total assets of a company are financed by the total debt. A higher ratio means that the company has higher leverage and higher financial risk. 

Debt to Equity Ratio = Total Debt / Shareholder’s Equity. 

The total debt divided by the shareholder’s equity is known as the Debt to Equity Ratio. This will show what proportion of total assets are funded by debt. The higher the ratio is, the higher the financial risk.

Efficiency Ratios

Efficiency ratios are also known as activity ratios or asset management ratios. It is defined as the company’s ability to make use of its assets to generate sales or revenue. The following are a few efficiency ratios used by many companies. 

Asset Turnover Ratio = Net Sales / Average Total Assets. 

Asset turnover ratio is a metric that shows how efficient the company is at generating sales from its total assets. It will also help in comparing a company’s performance with its competitors. 

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory. 

Inventory turnover is a measurement of how many times the company’s inventory is sold in a given time. As per Investopedia, “Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a given period.” 

The following is another frequently used efficiency ratio 

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable. 

Accounts Receivable Turnover ratio is used to find out how well the organization is collecting debts on the sales made on the credit term. The receivable turnover shows the firm’s effectiveness at collecting debts.

Conclusion

The financial health of a company can be easily gauged by using these financial ratios. It is advisable that every small business owner and sole trader should have a clear idea about these financial ratios. This will help them to measure and track the growth of their business. Ratios are a handy way to show the business’s financial statements in a shorter and precise manner. A financial analyst uses these ratios for checking how a company can pay its short and long-term debts. Financial ratios are a great help to financial analysts, investors, business owners, and managers to measure the financial health of a company.