Financial ratio fundamentals
Even if you hate accounting and think accountants are ‘bean counters’, running your business requires a basic understanding of some fundamental accounting principles. One of these fundamentals is financial ratios which can be helpful tools in understanding a company’s financial health. They are a benchmark by which you can compare your business to industry standards and analyse changes over time.
By using financial ratios you can get a snapshot of your company’s health. Three of the most common types of ratios fall into the categories of liquidity, debt and profitability. Here we’ll take you through what each ratio shows you, and you can calculate them.
1. Liquidity ratios
These financial ratios show a company’s ability to pay off short-term debt without raising additional capital.
a. Operating cash flow ratio
The operating cash flow shows the relation of cash flow that a company generates from operations to its current debt. This ratio shows how liquid a firm is in the short run since it connects current debt with cash flow from operations.
Operating cash flow ratio = cash flow from operations ÷ current liabilities
When the operating cash flow ratio is less than 1, the business is not generating sufficient cash to pay off its short-term debt. In this situation, the company might not be able to continue operating.
b. Current ratio
The current ratio measures a company’s ability to meet its short-term obligations.
Current ratio = current assets ÷ current liabilities
Current assets and liabilities are short-term assets and liabilities – it’s expected that current assets will be turned into cash and current liabilities paid within one year.
For example, a company with current assets of $1,500,000 and current liabilities of $700,000 has a current ratio of 2.14. A current ratio of 2.0 is often seen as acceptable, but will depend on the industry. In general, the more liquid a company’s current assets, the smaller the current ratio can be without causing concern.
c. Quick ratio
The quick ratio (also called ‘acid test’) is similar to the current ratio but it doesn’t include inventory.
Quick ratio = (current assets – inventory) ÷ current liabilities
A quick ratio of 1 is sometimes recommended, but will vary between industries. When inventory cannot be easily converted into cash, the quick ratio provides a more accurate measure of overall liquidity. When a firm’s inventory is liquid, the current ratio is better for measuring liquidity.
2. Debt ratios
These financial ratios show to what extent a business uses debt to fund its operations.
a. Debt ratio
The debt ratio measures the proportion of a firm’s total assets that are financed by its creditors. The higher the debt ratio, the more credit is being used by the firm.
Debt ratio = total liabilities ÷ total assets
For example, a company with $2,500,000 in total liabilities and $4,200,000 in total assets will have a debt ratio of 0.60, or 60 per cent. This debt ratio shows that 60 per cent of this company’s assets are financed with debt. Companies with high debt ratios are referred to as being ‘highly leveraged’.
Anywhere between 0.3 and 0.6 can be considered a good debt ratio, depending on the industry. Debt ratios under 0.4 are considered to be a lower risk.
b. Times interest earned ratio
This ratio measures a company’s ability to make contractual interest payments.
Times interest earned = earnings before interest and taxes ÷ interest
The higher the times interest earned ratio, the greater the firm’s ability to meet interest payment obligations.
For example, a company with earnings before interest and taxes of $1.9 million and annual interest obligations of $450,000 will have a times interest earned ratio of 4.2. A times interest earned ratio between 3.0 and 5.0 is considered to be acceptable in most cases.
3. Profitability ratios
These financial ratios indicate the ability of a business to generate profit relative to other factors.
a. Gross profit margin
This gross profit margin measures the percentage of profit remaining after the cost of goods – and not other expenses – have been paid. This ratio gives an indication of whether the average mark-up on goods and services is sufficient. The greater the gross margin, the more able a firm is to cover expenses and make a profit.
Gross profit margin = (sales – cost of goods sold) ÷ sales = gross profits ÷ sales
For example, a company with $6.5 million in sales and $4.7 million in cost of goods sold will have a gross margin of 28 per cent.
b. Net profit margin
The net profit margin measures the percentage of sales dollars remaining after the all expenses, including the cost of goods and taxes, have been paid. It is considered a key performance indicator of a firm’s success.
Net profit margin = net profits after taxes ÷ sales.
If a company has sales of $2.1 million and a net profit after taxes of $260,000, its net profit margin is 12 per cent.
Acceptable net profit margins vary between industries. A net profit margin of 2 per cent is not unusual for a supermarket, while a software company might have a net profit margin of 25 per cent.
Financial ratios can be an effective way to analyse your business performance over time and against industry averages. Your accountant can help you determine your financial ratios and how your business compares against standard benchmarks.
Overview of financial ratios
|Operating cash flow ratio||cash flow from operations ÷ current liabilities||> 1: business is not generating enough cash to pay off its short-term debt
>1: business is generating enough cash to pay off its short-term debt
|Current ratio||current assets ÷ current liabilities||A current ratio of 2 is often seen as acceptable but will depend on the industry.|
|Quick ratio||(current assets – inventory) ÷ current liabilities||A quick ratio of 1 is sometimes recommended but will vary between industries.|
|Debt ratio||total liabilities ÷ total assets||Anywhere between 0.3 and 0.6 can be considered a good debt ratio, depending on the industry. Debt ratios under 0.4 are considered to be a lower risk.|
|Times interest earned||earnings before interest and taxes ÷ interest||A times interest earned ratio between 3.0 and 5.0 is considered to be acceptable in most cases.|
|Gross profit margin||(sales – cost of goods sold) ÷ sales = gross profits ÷ sales||This varies widely depending on the industry. Can be useful to compare a company’s year-on-year performance.|
|Net profit margin||net profits after taxes ÷ sales||This ratio varies widely between industries. Can be useful to compare a company’s year-on-year performance.|