As a business owner, you should monitor and know the financial health of your business. This means you should understand financial ratios which tell the story of your business. Financial ratio analysis is not rocket science. It’s like personal finance but adapted in the context of your business.
You can also use ratio analysis to identify potential problem areas so you can troubleshoot them.
You can also use financial ratios to compare your business with your peers. By benchmarking your business to the best companies in your industry, you will know the areas in your business that needs to improve. Just comparing absolute numbers with a competitor is not useful because your scale of operations might be smaller than them. So even if they have a bigger total number that doesn’t necessarily mean that they are better than your business. The ratios would determine that.
This post will explore the key financial ratios that critically evaluate the financial health of your business. Also, you can use these ratios to evaluate buying shares of companies as an investor.
Basic Financial Statements
With the help of your bookkeeper or accountant, they will help you prepare your financial statements so that you can do ratio analysis.
The balance sheet provides a snapshot of the financial position of your business. It lists down the assets, liabilities, and the equity of your business.
The income statement or the profit and loss account reports the revenues and expenses of your business. As such it highlights your revenue streams, and after subtracting your expenses, you will know whether your operations are profitable or not.
The cash flow statement indicates the sources of your firm’s cash and how it is utilized.
These ratios measure your company’s ability to pay bills on time. As they say in business, “Cash is king.” If you have substantial cash pile, your business is very liquid and can take advantage of the surplus in cash for good investment opportunities.
- Current Ratio
The current ratio is a reflection of financial strength and solvency of your business. It calculates the number of times your current assets exceed your current liabilities.
Current Ratio Formula: Current Assets / Current Liabilities
Current Assets are any assets that your company has that can be converted into cash within the year. Cash is the most obvious current asset. If you have inventory, it can be sold and converted into cash. Another type of current asset is your accounts receivable. For example, one of your customers owes you money, e.g. they will only pay in three months’ time. There are some companies that buy these accounts receivables for a bit of a discount. You get cash immediately upon that sale.
Current Liabilities is what your business owes to another party that is due within the year.
Improving the current ratio
Therefore, if your current ratio falls below 1, this means your company is suffering from a liquidity crisis, i.e. it may not be able to pay creditors in time. The implication of this is that you might get slapped with late payment fees or a deterioration of relations with your creditors.
However, a current ratio that is too high, e.g. 2.5 and above, is also bad. It means that your current assets are not generating returns for you. It is staying idle. You can use more of your cash to boost the growth of your business.
So seek to have a current ratio that is above one but below 2. This will help creditors like banks trust you because they know that you can repay them easily.
If you are struggling to have a solid current ratio, try to boost liquidity by getting more cash sales and reducing your current liabilities. You can also improve your current ratio by paying off debt, selling fixed assets, and getting a long-term loan which will boost your cash pile.
A related measure for current ratio would be the working capital, which is the capital available to a business in meeting financial dues.
A high working capital figure means that it can weather unseen financial crisis, e.g. there is a recession or a natural calamity that wipes out a factory or a worker strike that cripples the business momentarily.
To find out your business’s working capital, you simply subtract your total current liability from the total current assets.
The higher your working capital is, the better.
Another name for this ratio is the “acid-test” ratio. This is because this ratio only looks at your most liquid assets and then compares them to your current liabilities. This ratio checks if your business is liquid in the most adverse situation possible.
This is a modification of the current ratio. Here, you remove inventory in your current assets. The reason is that inventory especially old or aged capital will not get the full value on the market if you sold it. You are lucky if you get half its value.
As such, the quick ratio is a more strict measure of your business’s liquidity. It tells you whether you can fund your daily operations and pay your regular expenses.
Quick Ratio Formula: (Current Assets- Inventory)/ (Current Liabilities)
If you get a quick ratio below 1, you should boost your cash reserves and lessen your current liabilities to improve this ratio.
Account receivable turnover
This ratio measures the number of times your accounts receivable is turned over during a period.
Accounts receivable refer to the amounts that are due to you by your customers. This ratio measures the efficiency of your business to collect these receivables from your customers. If your customers are perpetually late in paying you, then you will have a poor account receivable turnover. This can affect your liquidity because cash is not entering your business despite booking ‘sales.’
Accounts Receivable Turnover Formula: Total Net Sales/ Accounts Receivable
Net Sales refer to sales minus any allowances for returns on discounts while net accounts receivable means you subtract already any adjustments for bad debts.
Target at least a ratio of 3:1 or 4:1.
A high ratio indicates that your business enjoys a shorter time between making a sale and collecting the cash.
If you have a low ratio on this, this means you need to strengthen your collection team or fire your clients who are poor payers. Find better customers who are good payers. You should also put tighter limits on the credit that you give to your customers as well as finding better collection methods to help you collect better from your accounts receivables. This could involve invoicing sales daily and follow up on outstanding debtors regularly. You can also offer early settlement discounts to your debtors to encourage them to pay early. Finally, you can do routine credit checks on new non-cash customers so that you can avoid bad debts.
Days Inventory Turnover
If you sell products and hold an inventory of it, this ratio is very critical to monitor. Inventory turnover measures how many days inventory your company has on hand. This ratio is a good indication of your business’s purchasing and production efficiency.
Days Inventory Turnover Formula: 365/ (Cost of Goods Sold / Average Inventory)
If you get a high inventory turnover, this means that that you might have too much inventory and poor sales. You are unable to convert your inventory into sales and ultimately have difficulty converting it to cash. Holding inventory will incur costs for your business, e.g. storage costs or obsolescence costs wherein you have to sell your old inventory at a fraction of their original cost. A low inventory turnover could indicate that you are doing well in converting your inventory into cash and thus have low inventory. However, in the case of a sudden surge in demand, you might not be able to meet that demand because of a depleted inventory. In this way, too low inventory turnover could mean missed the opportunity to boost sales.
In general, modern inventory best practices are all about minimizing investments in inventories because of technologies such as just-in-time production.
Net Sales to Working Capital
This ratio measures the efficiency in the way working capital is used by your business. It shows how well your working capital is supporting your sales figures.
Net Sales to Working Capital Formula: Net Sales/Net Working Capital
If you get a low ratio, this means that your working capital is not working hard enough to generate sales. For example, you could use your working capital to invest in equipment or do marketing activities. On the other hand, a high ratio means that a sudden drop in sales could lead to significant cash shortage for your business. As always, compare this ratio with your competitors to make the analysis meaningful.
The following ratios assess how successful you are in managing your business in making profits from the sales and how well you use your assets and working capital. If you are an investor, these ratios tell you how good the management team is.
Profit Margin Ratio
Profit Margin Ratio Formula: Net Income/ Gross Sales Revenue
This ratio tells you the percentage of your sales that you turn to profit. How much of those sales is your profit? You might have massive sales but only get to keep a small portion of it. Unless you are in retail where you make it up via volume, having a low-profit margin ratio is a red flag. You will need to make a profit that will enable you to grow your business for the long term.
Cash Flow to Debt
This ratio is a predictor of business failure. Cash flow matters for a startup because if cash is not entering your business, you cannot meet your day to day operating expenses. It means you have to resort to debt to get some cash inflows. This situation will increase your leverage which makes you vulnerable to getting bankrupt.
Cash Flow to Debt Formula: (Net Income + Depreciation) / Total Debt
Try to get a ratio of more than one but less than two because too high of this ratio means you are not putting your capital to good use.
Return on Investment
This ratio is an important one to keep track of because this tells you how efficient your startup in using its assets to generate profit. It measures the amount of profit that your business earns relative to the total assets that you have bought for your business.
Return on Investment Formula: Net Income/ Total Assets
Target a high percentage as much as possible. If your rate is low compared to your peers in the industry, then it means you have to make your assets work more efficiently in helping you generate profit.
This ratio is also helpful in helping you determine potential investments in other businesses. If the return on investment is too low, it might not be worth the time and effort for you to invest your money in it. For example, stocks on average can give a return of 15% annually. If there is a business investment proposal on the table for you with a projected return on investment of 13%, then you might as well park your surplus funds in stocks.
Return on Equity
If you are running a private limited company, then that means you have shareholders in the business. This would be the more appropriate profitability measure for your business.
Return on Equity Formula: Net Income / Shareholder’s Equity
This ratio calculates how much profit has been generated by the investment of the shareholders. It is the return of the shareholders.
If you are looking to invest in a company, look for its return on equity. Determine whether it is doing well relative to its peers.
Warren Buffet has a minimum requirement of 15% return on equity before considering looking at a potential investment.
This ratio is straightforward. It measures how reliant your business on debt to finance your business.
Debt to Equity Ratio Formula: Total Liabilities/ Total Equity
The higher this ratio is, the riskier your business is because it is driven more by creditors. This means a big part of your cash flow is spent to paying off the debts.
Also, a high debt/equity ratio means that you will have difficulty getting additional credit because financial providers find you to be a risky prospect since you already have significant debt in your accounts.
However, a low debt/equity ratio could mean that your shareholders might not get a higher return on their investment because debt can be used to finance expansion and growth. Shareholders in a company following a successful growth strategy financed by high debt will find their returns increasing much faster than in a slower growth company not prepared to take risks through high borrowings.
Interest Service Coverage Ratio
A related ratio to this is interesting service coverage ratio. This ratio measures how much cash your business has to pay interest on your business debt.
Interest Service Coverage Ratio Formula: Net Operating Income / Interest Expense
If your business scores high on this ratio, your business will be able to meet its upcoming interest costs.
You can use investment ratios to evaluate whether to purchase shares of a company.
Dividend Yield Ratio
If you want to earn through primarily through dividends, you should know the dividend yield ratio.
Dividend Yield Ratio (%): (Dividend per share x 100) / Current Share Price
Try to see the trend of this ratio if it is consistent. Compare it also with its peers so that you can choose the one with the highest dividend yield and therefore get a bigger return.
Price Earnings Ratio (P/E Ratio)
Price Earnings Ratio formula: Current share price/earnings per share
This ratio gives an indication of how confident investors are regarding the prospects of the business. A high P/E ratio, in general, suggests that investors believe that the company will have high earnings growth in the future. A low P/E ratio indicates that investors are not too confident of the earnings capabilities of the company.
Using Ratio Analysis
Aside from calculating the ratios and comparing it to industry standards, you should use trend analysis. This means looking at the trend for your ratios for the past five years at least. This is also called horizontal analysis. The trends can highlight areas for your business to improve on.
Another way you can use ratio analysis is to observe your ratios over a full economic cycle. This will help you analyze how your company’s performance changes over different economic conditions such a recession. This can help you plan for those difficult times.
Your business evaluation using ratios should not end with the calculations and trend analysis and industry comparisons. You should be actively be seeking the root of the issues that the ratios indicate and employ strategies to solve them.
Limitations of Ratio Analysis
While ratio analysis is extremely useful and necessary for your monitoring and running of your business, it does have limitations.
For starters, if you compare your ratios with average companies, then your ratios might look good. Always seek to compare with the best companies in your industry. In this way, you will have the drive to improve the financial ratios of your business.
Another limitation of ratio analysis is that it does not take into account inflation because figures in the accounts are historical data. Since then, inflation might have occurred, and therefore figures that you use to calculate the ratios are now distorted. This is because inflation affects both inventory values and depreciation. Thus, if you do trend analysis and compare your ratios with different time periods, there can be some inaccuracy due to the inflation effect.
You should also be careful in making inter-firm industries. The different fiscal year ends for different businesses can make comparison inaccurate.
Another limitation is that companies may apply different accounting practices that can thus distort comparisons.
Financial Ratios only look at past figures. As such, it is difficult to use them to forecast the future. However, ratios can give an indication as for whether the trend is likely to persist or not and help you make a better investment decision.
Finally, financial ratios do not address qualitative information such as product quality, customer service, and employee morale. These things also contribute to whether your business will succeed or not.