Written by; Suzanne Cody CPA, CGA, Senior Partner
Just exactly what are financial ratios? In business, they are a measure of a company’s financial and operating performance. They are used to demonstrate the value of the business. They can be used to compare a business to other businesses in both similar and different industries as well as to analyse a company’s financial standings. They assist in identifying strengths and weaknesses.
There are four main categories of financial ratios:
The most common liquidity ratio is the current ratio, which is the ratio of current assets to current liabilities. This ratio indicates a company’s ability to pay its short-term bills. A ratio of greater than one is usually a minimum because anything less than one means the company has more liabilities than assets. A high ratio indicates more of a safety cushion, which increases flexibility although some of the inventory items and receivable balances may not be easily convertible to cash. Companies can improve the current ratio by paying down debt, converting short-term debt into long-term debt, collecting its receivables faster and buying inventory only when necessary.
Solvency ratios indicate financial stability because they measure a company’s debt relative to its assets and equity. A company with too much debt may not have the flexibility to manage its cash flow if interest rates rise or if business conditions deteriorate. The common solvency ratios are debt-to-asset and debt-to-equity. The debt-to-asset ratio is the ratio of total debt to total assets. The debt-to-equity ratio is the ratio of total debt to shareholders’ equity, which is the difference between total assets and total liabilities.
Profitability ratios indicate management’s ability to convert sales dollars into profits and cash flow. The common ratios are gross margin, operating margin and net income margin. The gross margin is the ratio of gross profits to sales. The gross profit is equal to sales minus cost of goods sold. The operating margin is the ratio of operating profits to sales and net income margin is the ratio of net income to sales. The operating profit is equal to the gross profit minus operating expenses, while the net income is equal to the operating profit minus interest and taxes. The return-on-asset ratio, which is the ratio of net income to total assets, measures a company’s effectiveness in deploying its assets to generate profits. The return-on-investment ratio, which is the ratio of net income to shareholders’ equity, indicates a company’s ability to generate a return for its owners.
Two common efficiency ratios are inventory turnover and receivables turnover. Inventory turnover is the ratio of cost of goods sold to inventory. A high inventory turnover ratio means that the company is successful in converting its inventory into sales. The receivables turnover ratio is the ratio of credit sales to accounts receivable, which tracks outstanding credit sales. A high accounts receivable turnover means that the company is successful in collecting its outstanding credit balances.