What Are Financial Ratios and Why Are They Important?
A good way to monitor the health of your business is to measure a number of different financial ratios. This article discusses common financial ratios and their uses.
It’s hard to take steps to support the growth of your company without first knowing how your organization stacks up to the competition. If you’re looking to assess the health of your company and identify opportunities for improvement, take a look at your company financial ratios. These can be useful indicators of how well your company is performing in a number of financial areas.
Financial ratios are calculated from information derived from your company’s financial statements. This includes your cash flow statement, balance sheet, and profit and loss (P&L) statement. Before you start calculating your company’s financial ratios, take a moment to gather relevant documents.
Why is financial ratio analysis important?
Analyzing your company’s financial ratios can provide you with valuable insights into profitability, liquidity, efficiency and more. These ratios can help you visualize how your company has performed over a given period of time. You can also compare your company’s financial ratios with industry averages to see how you compare to other businesses in your sector.
Financial ratios may also be used by investors to determine the health of a business. If your company is publicly traded, it’s a good idea to monitor key financial ratios, as these numbers can impact how investors view your company. By understanding the factors that affect these ratios, you can take steps to produce results that will be more attractive to investors.
Important financial ratios for companies
There are a number of different financial ratios that can be calculated, measured and monitored. Typically, ratios are not examined alone, but are looked at in combination with other performance indicators. Below, we cover some key financial ratios used to assess business performance.
Cash flow ratios
Cash flow is important for every business. Ratios that examine cash flow can help you determine the current state of your assets and identify areas in which the cash flow cycle can be accelerated.
Current assets / Current liabilities
The current ratio examines your company’s ability to pay off liabilities with your current assets. The value of your total assets and liabilities can be obtained from your balance sheet. The higher your current ratio is, the more likely you will be able to pay off your financial obligations in the near future.
Current assets – inventory / Current liabilities
Also known as the acid test ratio or cash ratio, the quick ratio is a good indicator of your company’s short-term liquidity. It tells you how many times liquid assets could be used to pay down your debt. Unlike the current ratio, the quick ratio disregards assets that cannot be easily converted into cash (such as inventory). If your quick ratio is between 1.5 and 2.0, this is usually considered healthy.
Accounts receivable days (AR days)
Accounts receivable / Net sales x 365
Receivables management is a vital component of ensuring strong cash flow. Accounts receivable days—sometimes referred to as days sales outstanding (DSO)—indicates how many days on average it takes to collect payments from your customers or clients. The ideal number of AR days differs from one industry to the next, but 45 days is usually considered to be a good number to shoot for. Higher numbers may indicate future cash flow problems.
You can adjust the time frame of this ratio by using data from a specific date range and changing the number of days as needed. If you’ve been taking steps to improve your cash flow and want to check if any progress has been made, it may be wise to calculate AR days quarterly or even monthly.
Leverage ratios measure a company’s debt compared to other financial metrics, such as equity or assets. They can help financial institutions estimate a company’s ability to pay back long-term debt. Below are some of the most commonly used leverage ratios.
Total debt / Equity
Growth is an admirable goal, but businesses who take on numerous high-interest loans to achieve this growth might end up in hot water once it comes time to make payments. The debt-to-equity ratio will help gauge your company’s debt capacity—in other words, it can help you determine whether or not you can safely assume additional debt. Lenders typically look for a debt-to-equity ratio of 2-to-1 or less when analyzing business loan requests.
Total debt / Assets
The debt-to-asset ratio shows how the value of your company’s assets compares to your total debt. A higher debt-to-asset ratio can be viewed as a sign of financial insecurity, as it indicates that a significant portion of your overall assets comes from liabilities such as commercial loans.
Interest coverage ratio
Operating income / Interest expenses
While debt-to-equity and debt-to-asset ratios are meant to show your company’s ability to pay off debt, the interest coverage ratio focuses specifically on how much interest your company owes on its outstanding debt. It’s calculated by dividing your earnings by your interest payments due within a given time period. This type of ratio is also referred to as the times interest earned ratio.
>>Related Reading: 5 Common Reasons Small Business Loans Are Denied (and How to Avoid Them)
Profitability ratios are used to measure how much income a company is able to generate after accounting for factors such as operating costs, taxes and debt payments. These ratios are crucial for business owners as well as potential investors who may be researching your company.
Gross profit margin
Net sales - cost of goods sold / Net sales
How much money is your company making as a percentage of sales? To find your gross profit margin, you subtract the cost of goods sold from your net sales amount, then divide this number by net sales. You’ll end up with a percentage that shows you how your profits compare to the cost of producing goods.
Operating profit margin
Operating income / Net sales
Unlike gross profit margin, operating profit margin takes into account your expenses. To calculate your operating profit margin, you take your operating income and divide it by your net sales for the period. This can give you a more realistic look of your company’s profitability.
Earnings before interest, taxes, depreciation and amortization (EBITDA) margin
EBITDA / Net sales
Your EBITDA margin is a key measurement that investors and potential acquirers look at, since it offers the truest picture of your company’s profitability. EBITDA shows what your company’s net profits look like before factoring in details such as interest, taxes and depreciation. This number is then divided by your net sales to determine your EBITDA margin.
Which financial ratios should you measure?
With so many financial ratios out there, it can be difficult to know which ones you should frequently calculate and monitor. Ultimately, you should focus on areas of your business that are currently of the highest priority to your treasury department and executive suite.
For example, if you’re about to start a new project that will require substantial funding, you may want to focus on reducing your existing debt-to-equity ratio before taking out an additional commercial loan. If your organization is having trouble meeting its monthly expenses, cash flow ratios can help you uncover opportunities to strengthen cash flow and improve your accounts receivable processes.
Alternatively, if your organization is in a good financial position and is primarily focused on finding ways to support growth and attract investors, then profitability ratios may be the most important types of ratios to monitor.
Benchmark your most important financial ratios
Keep in mind that financial ratios in and of themselves may not always be useful. Company financial ratios should be compared against prior performance periods or industry averages to see if financial performance is improving or declining. This type of analysis can also show you how you stack up against the competition.
For more information on how financial ratios can be used to support your business, contact a Cadence Bank Treasury Officer. Cadence Bank offers a range of treasury management services designed to help you improve the efficiency and profitability of your company. Our solutions include:
This article is provided as a free service to you and is for general informational purposes only. Cadence Bank makes no representations or warranties as to the accuracy, completeness or timeliness of the content in the article. The article is not intended to provide legal, accounting or tax advice and should not be relied upon for such purposes.