10 Finance Ratios from Financial Statement to Analyze Your Business

Analyzing your business's financial health is crucial for making informed decisions. The Current Ratio, which is calculated by dividing current assets by current liabilities, is a great starting point. It shows whether your business can pay its short-term debts.

A Current Ratio of 1 or higher is generally considered healthy. This means your business has enough liquid assets to cover its short-term debts. For example, if your Current Ratio is 2, it means you have twice as many current assets as current liabilities.

The Debt-to-Equity Ratio is another important metric. It's calculated by dividing total debt by total equity. It shows how much of your business is financed by debt versus equity. A higher ratio indicates more debt, which can be a concern.

A high Debt-to-Equity Ratio can make it difficult to secure additional funding or attract investors. It's essential to keep an eye on this ratio and make adjustments as needed.

A business with high liquidity can turn its assets into cash quickly to pay off debts or make investments. This is crucial for withstanding periods of tight cash flow.

Liquidity ratios measure a business's ability to cover short-term obligations, such as accounts payable and accrued expenses. A higher liquidity ratio indicates a business can settle its debts with its existing current assets.

The current ratio, also known as the working capital ratio, estimates a business's ability to pay short-term obligations. Ideally, the current ratio will be greater than one, meaning a business can settle every dollar owed with its existing current assets.

Brett's Bakery has a current ratio of 2, which is calculated by dividing its current assets ($260,000) by its current liabilities ($130,000).

The quick ratio, also known as the acid-test ratio, measures a business's ability to pay off short-term liabilities with quick assets. It's one of the best measures of liquidity. A quick ratio of 1.0 or greater indicates a business can cover its short-term liabilities with its quick assets.

To calculate the quick ratio, only include current assets that are in cash or can be readily converted into cash, and current liabilities that may need to be met quickly. For example, Brett's Bakery's quick ratio is 1.92, calculated by dividing its current assets ($260,000 - $10,000) by its current liabilities ($130,000).

A business's liquidity position can be assessed against its need for liquidity, represented by its sales. The net working capital to sales ratio measures this by dividing current assets minus current liabilities by sales.

Here are some common liquidity ratios:

These ratios can help a business understand its liquidity position and make informed decisions about its financial management.

Profitability is a key aspect of any business, and there are several financial ratios that can help you measure it. A high return on equity (ROE), for example, indicates that your business is good at generating value for its owners. Aim for a high ROE, as it shows your business can generate cash internally.

The return on assets (ROA) ratio measures how well your company is performing by comparing your profits to the capital you've invested in assets. A higher ROA indicates that you're using your economic resources more efficiently. For instance, Brett's Bakery has a net profit of $45,000 and a total value of assets of $600,000, giving it an assets ratio of 7.5%.

Here are some general guidelines to determine if your company's ROE is reasonable:

The profit margin ratio measures the amount of net income earned with each dollar of sales generated by the company. A good profit margin ratio varies by industry, so it's helpful to benchmark your results against your competitors. For example, the NYU Stern School of Business provides a database of profit margins by sector.

Return on Assets is a key indicator of how efficiently a company uses its economic resources to generate profits. It's calculated by dividing Net Income by Average Total Assets.

Brett's Bakery, for example, has a return on assets ratio of 7.5%, which means they're making $45,000 in profit on a total asset value of $600,000. A higher ROA indicates that a company is using its assets more efficiently.

Comparing your ROA to other companies in your industry can be helpful, but it's more important to track how your ROA changes over time. If your ROA is rising from year to year, it's a good sign that you're squeezing more profits out of each dollar of assets.

A declining ROA, on the other hand, can indicate that you've made some bad investments. It's essential to monitor your ROA regularly to ensure that your business is performing efficiently.

Aiming for a high return on assets is a good goal for any business, as it indicates that you're generating cash internally.

Return on Equity (ROE) is a key indicator of a company's profitability. It measures the company's ability to generate profits from shareholder investments into the business.

A good ROE depends on your industry, with electronics companies averaging around 44% and engineering and construction companies averaging just above 6%. This highlights the importance of considering industry norms when evaluating a company's ROE.

To calculate ROE, you divide net income by shareholders' equity. For example, if a company has a net income of $560,000 and shareholders' equity of $2,800,000, its ROE would be 20%.

Here are some general guidelines for ROE:

A high ROE indicates that a company is good at generating value for its shareholders, while a declining ROE can signal poor decision-making on reinvesting capital in unproductive assets.

Inventory Turnover measures how efficiently you manage inventory. It's a key financial ratio that helps you understand how quickly your business sells its inventory.

The Inventory Turnover Ratio is calculated by dividing the Cost of Goods Sold by the Average Inventory. For example, if your Cost of Goods Sold is $280,000 and your Average Inventory is $70,000, your Inventory Turnover Ratio is 4 times in the year ($280,000 / $70,000).

A high Inventory Turnover Ratio is preferred, as it indicates that your business is selling its inventory quickly. However, be aware that some products may not sell as quickly as others, so it's essential to consider the industry average and your company's specific needs.

Here's a rough guide to Inventory Turnover Ratios:

Keep in mind that these are general guidelines and may vary depending on your specific business and industry. The goal is to have a high Inventory Turnover Ratio while still maintaining a sufficient stock level to meet customer demand.

Remember, a low Inventory Turnover Ratio can indicate that your sales are poor or you're carrying too much inventory, which can lead to cash flow problems and other issues.

Financial leverage is a crucial aspect of a company's financial health, and it's measured by several key ratios. A company's debt to equity ratio is a good indicator of its financial leverage, and it's calculated by dividing total liabilities by total stockholders' equity.

A debt to equity ratio of 2.57, as seen in Example 4A, indicates that a company is highly leveraged, which can be a concern for lenders and creditors. On the other hand, a ratio of 0.82, as seen in Example 4B, suggests that a company is using less debt than equity, which is generally a good sign.

Investors and creditors look for a debt to equity ratio that's around 2 or 2.5, which means that for every dollar shareholders invest, about 66 cents comes from debt and 33 cents from equity. However, companies with consistent cash flows might be able to sustain a higher ratio without running into problems.

Here's a rough guide to interpreting debt to equity ratios:

Keep in mind that a good debt to equity ratio varies by industry, so it's essential to compare a company's ratio to its peers and industry average.

Asset Management is a crucial aspect of any business, and financial ratios can help you measure its efficiency. A high return on assets (ROA) indicates that your company is performing well by comparing profits to the capital invested in assets.

The debt to total assets ratio shows the percentage of assets financed by creditors. A lower ratio is generally better since it indicates less risk of loss for lenders. Most investors prefer companies with a debt to total assets ratio below 1.

A common-size balance sheet, resulting from vertical analysis, allows you to compare percentages to other companies even if their amounts are vastly different in size. This can be useful in understanding a company's asset management efficiency.

Here are some key asset management ratios to consider:

These ratios can help you identify areas for improvement in your company's asset management and make informed decisions to increase efficiency and reduce costs.

Vertical analysis is a powerful tool for understanding a company's financial health. It involves expressing every income statement amount as a percent of net sales, and every balance sheet amount as a percent of total assets.

This technique allows for easy comparison of financial statements between companies, even if their amounts are vastly different in size. By presenting financial statements as percentages, common-size financial statements are created, making it easier to spot trends and areas for improvement.

Expressing every income statement amount as a percent of net sales is a key part of vertical analysis. This is done by dividing each amount by the company's net sales. The same is true for the balance sheet, where each amount is divided by the company's total assets.

A company's internal income statement and balance sheet will often display these percentages next to each dollar amount. This provides a clear picture of how each item contributes to the company's overall financial health.

The percentages on a common-size balance sheet allow you to immediately see the debt to total asset ratio, stockholders' equity, and other key metrics. For example, if a company's debt to total asset ratio is 62.5%, you know that debt accounts for 62.5% of the company's total assets.

Here are some key benefits of vertical analysis:

A company's balance sheet provides a snapshot of its financial situation at a particular moment in time. It's a crucial tool for asset management.

The debt to total assets ratio is a key indicator of a company's financial leverage. This ratio shows the percentage of a business's assets that have been financed by debt or creditors. A lower ratio of debt to total assets is generally better, as it indicates less risk and a company's ability to obtain additional loans if needed.

A debt to total assets ratio of 72% may be acceptable for a growing company, but it can be risky for a company with declining demand and poor management. On the other hand, a lower ratio of 45% may be a sign of a company's ability to manage its debt effectively.

Here are some key facts about the debt to total assets ratio:

A common-size balance sheet, also known as a vertical analysis, allows you to compare a company's financial statements to other companies even if their amounts are vastly different in size. This is achieved by expressing each item on the balance sheet as a percentage of the company's total assets.

The percentages on a common-size balance sheet can give you valuable insights into a company's financial situation. For example, a debt to total asset ratio of 62.5% indicates that a company's total liabilities are 62.5% of its total assets.

In the world of finance, having a solid understanding of financial ratios is crucial for making informed decisions.

The current ratio, for instance, is a measure of a company's liquidity, calculated by dividing current assets by current liabilities.

It's essential to have a high current ratio, ideally above 1, to ensure the company can pay off its debts.

The debt-to-equity ratio, on the other hand, shows how much debt a company is carrying compared to its equity.

A debt-to-equity ratio above 1 indicates a company is more in debt than it has in equity.

The return on equity (ROE) ratio measures a company's profitability by dividing net income by shareholder equity.

A high ROE ratio, above 15%, indicates a company is efficiently generating profits for its shareholders.

The asset turnover ratio measures a company's efficiency in generating sales from its assets.

A high asset turnover ratio, above 2, indicates a company is using its assets effectively to generate sales.

The interest coverage ratio measures a company's ability to pay its interest expenses from its earnings before interest and taxes (EBIT).

A high interest coverage ratio, above 3, indicates a company can easily pay its interest expenses.

Calculating ratios is a crucial step in analyzing a company's financial health. You can calculate ratios using amounts from the balance sheet, income statement, or statement of cash flows.

To calculate the debt to equity ratio, you need to divide the total debt by the owner's equity. This ratio shows the amount of total debt and financial liabilities against owner's equity.

The working capital, current ratio, and quick ratio can be calculated using the balance sheet. These ratios show the company's liquidity and ability to pay its short-term debts.

The debt to total assets ratio can be calculated by dividing the total debt by the total assets. This ratio shows the percentage of the company's assets that are financed by debt.

You can calculate the gross margin, profit margin, earnings per share, and times interest earned using the income statement. These ratios show the company's profitability and efficiency.

To calculate the free cash flow, you need to use the statement of cash flows. Free cash flow is the amount of cash a company generates after paying its debts and investing in new assets.

Here are the four financial ratios using amounts from the balance sheet:

Remember, the key to calculating ratios is to use the correct formula and to have the necessary amounts from the financial statements.