A financial ratio is a measure of the relationship between two or more components on the company’s financial statements. They enable a business to benchmark its performance.
Ratios help business leaders compare the company with competitors and more generally with those within their given industry. These ratios give you a quick and straightforward way to track performance, benchmark against those within an industry, spot trouble and proactively put solutions in place. They help companies see problematic areas and put measures in place to prevent or ease potential issues. And if the business is seeking outside funding from a bank or an investor, financial ratios provide those stakeholders with the information needed to see if the business will be able to pay the money back and produce a strong return on investment.
Key Financial Ratios
Ratios help business leaders compare the company with competitors and more generally with those within their given industry. They enable a business to benchmark its performance and target areas for improvement. They help companies see problematic areas and put measures in place to prevent or ease potential issues. And if the business is seeking outside funding from a bank or an investor, financial ratios provide those stakeholders with the information needed to see if the business will be able to pay the money back and produce a strong return on investment.
Ratios that helps to determine profitability are as follows :
1. Gross profit margin (GP Ratio)
Higher gross profit margins indicate the company is efficiently converting its product (or service) into profits. The cost of goods sold is the total amount to produce a product, including materials and labor. Net sales is revenue minus returns, discounts and sales allowances.
Gross Profit Margin = Net sales – Cost of Goods or Services sold / Net Sales X 100
2. Net profit margin (NP Ratio)
Higher net profit margins show that the company is efficiently converting sales into profit. Look at similar companies to benchmark success as net profit margins will vary by industry.
Net Profit Margin = Net Profit / Sales X 100
3. Operating profit margin
Increasing operating margins can indicate better management and cost controls within a company.
Operating Profit Margin = Gross Profit – Operating Expenses / Revenue X 100
Note : Gross profit minus operating expenses is also known as earnings before interest and taxes (EBIT).
4. Return on equity
This measures the rate of return shareholders get on their investment after taxes.
Return on Equity = Net Profit / Shareholder’s Equity
Ratios that helps to measure liquidity are as follows :
5. Working capital or Current ratio
Can the business meet short-term obligations? A working capital ratio of 1 or higher means the business’ assets exceed the value of its liabilities. The working capital ratio is also known as the current ratio.
Working Capital Ratio/ Current Ratio = Current Assets / Current Liabilities
6. Cash ratio
This measure is similar to the working capital ratio, but only takes cash and cash equivalents into account. This will not include inventory.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Note : Cash equivalents are investments that mature within 90 days, such as some short-term bonds and treasury bills.
7. Quick ratio
Similar to the cash ratio, but also takes into account assets that can be converted quickly into cash.
Quick Ratio = Current Assets – Inventory – Prepaid Expenses / Current Liabilities
8. Operating cash flow to net sales ratio
Measures how much cash the business generates relative to sales. Accounting Tools says this number should stay the same as sales increase. If it’s declining, it could be a sign of cash flow problems.
Operating Cash Flow to Net Sales Ratio = Operating Cash Flow / Net Sales
Ratios that helps to measure operational efficiency are as follows :
9. Revenue per employee
How efficient and productive are employees? This ratio is a good way to see how efficiently a business manages its workforce and should be benchmarked against similar businesses.
Revenue per Employee = Annual Revenue / Average number of employees in the same year
10. Return on total assets
Looks at the efficiency of assets in generating a profit.
Return on Total Assets = Net Income / Average total assets
Note : Calculate average total assets by adding up all assets at the end of the year plus all the assets at the end of the prior year and divide that by 2.
11. Inventory turnover
Examines how efficiently the company sells inventory. Start with the average inventory by taking the inventory balance from a specific period (a quarter, for example) and add it to the prior quarter inventory balance. Divide that by two for the average inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventory
12. Average collection
This is a related measure to give a business the sense of how long it takes for customers to pay their bills. Here’s the formula to calculate the average collection period for a given year.
Average Collection = 365 X Accounts Receivable Turnover Ratio / Net Credit Sales
To calculate net credit sales, use this formula:
Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances
13. Days Sales Outstanding
Shows how long on average it takes for customers to pay a company for goods and services.
Days Sales Outstanding = Accounts Receivable for a given period / Total Credit Sales X Number of days in the period
Ratios that helps to help determine solvency are as follows :
14. Debt to equity ratio
An indication of a company’s ability to repay loans.
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
15. Debt to asset ratio
Gives a sense of how much the company is financing its assets. A high debt to asset ratio could be a sign of financial trouble.
Debt to Asset Ratio = Total Liabilities/Total Assets
Importance of Ratio Analysis
Ratio analysis is important for the company to analyze its financial position, liquidity, profitability, risk, solvency, efficiency, operations effectiveness, and proper utilization of funds which also indicates the trend or comparison of financial results that can be helpful for decision making for investment by shareholders of the company. Some of the important reasons for using ratios analysis in the business are as follows :
● Analysis of Financial Statements
● Analysis of operational efficiency of the firms
● Helps in understanding the Profitability of the company
● Helps in identifying the Business and Financial Risks of the firm
● For Planning and Future Forecasting of the firm
● To Compare the Performance of the firm
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