Financial ratios provide business owners a way to evaluate their company’s performance and compare it other similar businesses in their industry.
Financial ratios provide an objective way to compare and evaluate the relationships between different components of your financial information. They are used most effectively when results over several periods are compared. This allows you to follow your company’s performance over time and uncover signs of trouble.
Here are several key financial ratios every business owner should track to measure the financial health of your business. Each ratio gives you a different insight into your business.
Profitability Ratios – measure how efficiently a company uses its assets and how efficiently the company manages its operations
Profit Margin = Net Income / Net sales
Shows the net income generated by each dollar of sales. It measures the percentage of sales revenue retained by the company after operating expenses, interest and taxes have been paid. It’s a good indicator of your ability to control costs.
Return On Equity (ROE) = Net income / Average Total Equity
Indicates the amount of after-tax profit generated for each dollar of equity. A measure of the rate of return the owners received on their investment.
Coverage Ratio = Income Before Interest and Taxes / Annual Interest Expense
Measures a business's ability to meet its interest payment obligations.
Return On Assets (ROA) = Operating Income / Average Total Assets
Measures the owner’s efficiency in using the business’ assets to generate profit. It measures the productivity of assets, regardless of how they are financed (operating income excludes interest expense)
Liquidity Ratios – provide insights about a company’s ability to pay its bills over the short run without undue stress.
Working Capital Ratio = Current Assets / Current Liabilities
Indicates whether a business the ability to meet short-term obligations. A ratio of 1 or greater is considered acceptable for most businesses.
Quick Ratio = Quick Assets / Current Liabilities
Indicates a company's ability to pay its short-term debt obligations, using its most liquid (quick) assets: cash, marketable securities and accounts receivable.
Leverage Ratios – provides information about a company’s long-run ability to meet its obligations.
Debt Ratio = Total Liabilities / Total Assets
Shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness.
Debt-to-Equity Ratio = Total Liabilities / Total Equity
Measures how much debt a business is carrying as compared to the amount invested by its owners. It indicates the relative size of the owner’s equity position and is used as a measure of a business’s capacity to repay its debts.
Utilization (Asset Management) Ratios – these are measures of turnover that describe how efficiently, or intensively, a company uses its assets to generate sales.
Inventory Turnover = Cost of goods sold / Average inventory
Indicates how quickly inventory sells.
Days Inventory Outstanding (DIO) or Days to sell inventory = Days in the period / Inventory Turnover
Measures the number of days it takes for the company’s inventory to turnover, or to be converted to sales, either as cash or accounts receivable
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Indicates how quickly receivable are collected. A higher turnover rate generally indicates that less money is tied up in accounts receivable because customers are paying quickly.
Days Sales Outstanding (DSO) or Average Collection Period = Days in the period / Accounts Receivable Turnover
Indicates the number of days customers are taking to pay their bills.
Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable
Indicates how quickly a company pays its suppliers. A higher turnover rate generally indicates that more of a company’s funds are used to pay its suppliers quickly.
Days Payables Outstanding (DPO) or Average Days Payable = Days in the period X Average accounts payable / Total amount of purchases on credit
Measures the average number of days a company takes to pay suppliers.
Cash Conversion Cycle = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payables Outstanding (DPO)
Expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the number of days a company's cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company's working capital position is.