FINANCIAL MANAGEMENT RATIOS
What are
financial ratios?
Financial ratios are basic calculations using quantitative data from a
company’s financial statements. They are used to get insights and
important information on the company’s performance, profitability, and
financial health.
Common financial ratios come from a company’s balance sheet, income
statement, and cash flow statement.
Businesses use financial ratios to determine liquidity, debt concentration,
growth, profitability, and market value.
Why are financial ratios so important?
Financial ratios are sometimes referred to as accounting ratios or finance
ratios. These ratios are important for assessing how a company generates
revenue and profits using business expenses and assets in a given period.
Internal and external stakeholders use financial ratios for competitor
analysis, market valuation, benchmarking, and performance
management.
Financial Ratios inside a business
Financial planning and analysis professionals calculate financial ratios for
the following reasons for internal reasons.
● To measure return on capital investments
● To calculate profit margins
● To assess a company’s efficiency and how costs are allocated
● To determine how much debt is used to finance operations
● To identify trends in profitability
● To manage working capital and short-term funding requirements
● To identify operating bottlenecks and assess inventory management
systems
● To measure a company’s ability to settle debt and liabilities
5 Essential Financial Ratios for Every Business
The common financial ratios every business should track are
1) liquidity ratios
2) leverage ratios
3)efficiency ratio
4) profitability ratios and
5) market value ratios
1) Liquidity ratios
Liquidity ratios measure a company’s capacity to meet its
short-term obligations and are a vital indicator of its financial health. Liquidity is
different from solvency, which measures a company’s ability to pay all its
debts.
There are different forms of liquidity ratio.
Current ratio: Current Assets / Current Liabilities
The current ratio measures how a business’s current assets, such as cash,
cash equivalents, accounts receivable, and inventories, are used to settle
current liabilities such as accounts payable.
Quick ratio (Acid-test ratio): (Current Assets – Inventories – Prepaid
Expenses) / Current Liabilities
2) Leverage ratios
Companies often use short and long-term
debt to finance business operations. Leverage ratios measure how much
debt a company has.
” The types of leverage ratio to consider are:
Debt ratio: Total Debt / Total Assets
The debt ratio measures the proportion of debt a company has to its total
assets. A high debt ratio indicates that a company is highly leveraged.
Debt to equity ratio: Total Debt / Total Equity
The debt-to-equity ratio measures a company’s debt liability compared to
shareholders’ equity. This ratio is important for investors because debt
obligations often have a higher priority if a company goes bankrupt.
Interest coverage ratio: EBIT / Interest expenses
Companies generally pay interest on corporate debt. The interest
coverage ratio shows if a company’s revenue after operating expenses
can cover interest liabilities.
3. Efficiency ratios
Efficiency ratios show how effectively a company uses working capital to
generate sales.
There are several ways to analyze efficiency ratios:
Asset turnover ratio: Net sales / Average total assets
Companies use assets to generate sales. The asset turnover ratio
measures how much net sales are made from average assets.
Inventory turnover: Cost of goods sold / Average value of inventory
For companies in the manufacturing and production industries with high
inventory levels, inventory turnover is an important ratio that measures
how often inventory is used and replaced for operations.
Days sales in inventory ratio: Value of Inventory / Cost of goods sold x
(no. of days in the period)
Holding inventory for too long may not be efficient. The day sales in
inventory ratio calculates how long a business holds inventories before
they are converted to finished products or sold to customers.
Payables turnover ratio: Cost of Goods sold (or net credit purchases) /
Average Accounts Payable
The payables turnover ratio calculates how quickly a business pays its
suppliers and creditors.
Days payables outstanding (DPO): (Average Accounts Payable / Cost
of Goods Sold) x Number of Days in Accounting Period (or year)
This ratio shows how many days it takes a company to pay off suppliers
and vendors. A lower days payables outstanding implies that a business is
letting go of cash too quickly and may not be taking advantage of longer
credit terms. On the other hand, when the DPO is too high, it means a
company delays paying its suppliers, which can lead to disputes.
Receivables turnover ratio: Net credit sales / Average accounts
receivable
Accounts receivables are credit sales made to customers. It is important
that companies can readily convert account receivables to cash. Slow
paying customers reduce a business’s ability to generate cash from their
accounts receivable.
4) Profitability ratios
A business’s profit is calculated as net sales less expenses. Profitability
ratios measure how a company generates profits using available
resources over a given period.
Gross margin: Gross profit / Net sales
Operating margin: Operating income / Net sales
Return on assets (ROA): Net income / Total assets
Return on equity (ROE): Net income / Total equity
5) Market Value ratios
Market value ratios are used to measure how valuable a company is.
These ratios are usually used by external stakeholders such as investors
or market analysts but can also be used by internal management to
monitor value per company share.
Earnings per share ratio (EPS): (Net Income – Preferred Dividends) /
End-of-Period Common Shares Outstanding
The earnings per share ratio, also known as EPS, shows how much profit is
attributable to each company share.
Price earnings ratio (P/E): Share price / Earnings per share
Best Practices For Using Financial Ratios
Financial ratios help senior management and external stakeholders
measure a company’s performance. These best practices will drive
effective decision-making.
● Compute financial ratios with accurate financial numbers
● Compare ratios across periods to identify performance trends
● Use relative competitor and industry benchmarks to measure
performance
● Calculate ratios using balance sheet averages where applicable
● Interpret financial ratios correctly to support key business decisions
● Calculate and analyze ratios using the balance sheet, income
statement, and cash flow statement to get a holistic view of the business’s
performance
Final Thoughts
Financial ratios are good key performance indicators used to measure a
company’s performance over time compared to competitors and the
industry. Calculating accurate financial ratios and interpreting the ratios
help business leaders and investors make the right decisions.
