Mastering average financial ratios is a crucial step for any business looking to improve its financial health. A good starting point is to understand the current state of your business through key financial metrics.
The current ratio, for instance, is a measure of a company's ability to pay its short-term debts. It's calculated by dividing current assets by current liabilities, and a ratio of 2:1 or higher is generally considered healthy.
A low current ratio can indicate liquidity issues, which can be a major problem for businesses. On the other hand, a high current ratio suggests that a company has enough liquid assets to cover its short-term debts.
The debt-to-equity ratio is another important metric that measures a company's level of indebtedness. It's calculated by dividing total liabilities by total equity, and a ratio of 1:1 or lower is generally considered acceptable.
A high debt-to-equity ratio can be a red flag, indicating that a company is taking on too much debt. This can put the business at risk of financial distress if interest rates rise or if the economy slows down.
The return on equity (ROE) ratio measures a company's profitability by comparing net income to shareholder equity. A high ROE ratio indicates that a company is generating strong profits from its equity.
A high ROE ratio is a sign of a well-managed company that's able to generate profits efficiently. It's a key metric for investors looking to gauge a company's financial health.
The asset turnover ratio measures a company's efficiency in generating sales from its assets. It's calculated by dividing net sales by total assets, and a high ratio indicates that a company is making the most of its assets.
A high asset turnover ratio is a sign of a company that's operating efficiently and effectively. It's a key metric for businesses looking to improve their financial performance.
What Are Financial Ratios?
Financial ratios are a way to connect two amounts from a company's financial statements, such as the balance sheet and income statement, to understand their operations and debt usage.
These ratios are also known as financial ratio analysis or ratio analysis, which is part of financial statement analysis that also includes vertical and horizontal analysis.
Financial ratios are used to assess a company's financial health, which is why it's essential to understand what they mean.
Internal and external stakeholders use financial ratios to compare companies, evaluate market value, and manage performance.
Financial ratios are considered the best indicator of a company's financial health, making them a crucial tool for anyone interested in business.
Calculating Financial Ratios
Calculating financial ratios is a crucial step in understanding a company's performance. You can calculate ratios using amounts from the balance sheet, income statement, or statement of cash flows.
To calculate ratios using amounts from the balance sheet, you'll need to use the amounts from the balance sheet, such as the current ratio and quick ratio. For example, Example Corporation's balance sheet shows that its working capital as of December 31, 2023, was $____________.
To calculate ratios using amounts from the income statement, you'll need to use the amounts from the income statement, such as the gross margin and profit margin. For example, Example Corporation's income statement shows that its gross margin for the year ended December 31, 2023, was __________.
You can also calculate ratios using amounts from the statement of cash flows, such as the free cash flow. For example, Example Corporation's statement of cash flows shows that its free cash flow for the year 2023 was ________________.
Here are some key ratios to calculate:
- Working capital
- Current ratio
- Quick ratio
- Debt to equity ratio
- Debt to total assets ratio
- Gross margin
- Profit margin
- Earnings per share
- Times interest earned
- Free cash flow
From Income Statement
Calculating financial ratios from an income statement can be a bit more complex than using a balance sheet, but it's still a crucial step in understanding a company's financial health. You'll need to use specific line items from the income statement to calculate ratios like gross margin, profit margin, and earnings per share.
The gross margin ratio, for example, is calculated by dividing gross profit by net sales. This ratio shows the percentage of revenue that's left after accounting for the cost of goods sold. In Example Corporation's income statement, the gross margin ratio is calculated by dividing $150,000 (gross profit) by $600,000 (net sales), resulting in a gross margin of 25%.
To calculate the profit margin ratio, you'll divide net income by net sales. This ratio shows the percentage of revenue that's left after accounting for all expenses, including cost of goods sold, operating expenses, and taxes. In Example Corporation's income statement, the profit margin ratio is calculated by dividing $30,000 (net income) by $600,000 (net sales), resulting in a profit margin of 5%.
Earnings per share (EPS) is another important ratio that can be calculated using an income statement. It's calculated by dividing net income by the number of outstanding shares. In Example Corporation's income statement, the EPS is calculated by dividing $30,000 (net income) by 10,000 (number of outstanding shares), resulting in an EPS of $3.
Here's a summary of the ratios you can calculate using an income statement:
- Gross margin ratio: Gross profit / Net sales
- Profit margin ratio: Net income / Net sales
- Earnings per share (EPS): Net income / Number of outstanding shares
- Times interest earned: Earnings before interest and taxes (EBIT) / Interest expense
Time Series Analysis
Time Series Analysis is a type of trend analysis that compares amounts from multiple years. It's a way to see how financial metrics change over time.
By looking at a trend analysis table, you can quickly identify which areas of your business are improving or declining. For instance, if you're looking at the table from the trend analysis example, you can see that debits and credits are increasing over the past five years.
Analyzing financial statements over time can help you make informed decisions about your business. For example, if your income statement shows a steady increase in revenue, you may want to invest in more inventory to meet growing demand.
A trend analysis can also help you identify areas where you need to improve. For example, if your cash flow statement shows a decline in cash reserves, you may need to adjust your budget to prioritize saving.
Here's a breakdown of the types of financial metrics that can be analyzed in a trend analysis:
- Debits and Credits
- Adjusting Entries
- Financial Statements
- Balance Sheet
- Income Statement
- Cash Flow Statement
- Working Capital and Liquidity
- Financial Ratios
- Bank Reconciliation
- Accounts Receivable and Bad Debts Expense
- Inventory and Cost of Goods Sold
- Depreciation
- Payroll Accounting
Interpreting Financial Ratios
A financial ratio is only useful if you can interpret it correctly. According to Example 2, the debt to equity ratio is calculated by dividing a company's total amount of liabilities by its total amount of stockholders' equity. This ratio can be a key indicator of a company's financial health.
To interpret this ratio, you need to compare it to the industry average and the competitors' ratios. As Example 4B shows, Beta Company's debt to equity ratio of 0.82 indicates that it has used less of its creditors' money than the amount of its owner's money. This looks good.
However, if a company's debt to equity ratio is too high, it can be a sign of financial risk. As Example 4A shows, ABC Corporation's debt to equity ratio of 2.57 indicates that it is highly leveraged, which could be a factor in whether the corporation can borrow more money if needed.
It's also essential to consider the pros and cons of using debt instead of equity when purchasing business assets. As Example 2 mentions, using some debt is considered wise because interest on debt is deductible from the taxable income of a U.S. corporation.
Here's a quick reference guide to help you interpret financial ratios:
Keep in mind that financial ratios are not the only factor to consider when evaluating a company's performance. You should also compare financial ratios with that of major competitors to identify whether a company is performing better or worse than the industry average, as Example 3 explains.
Common Financial Ratios
The current ratio is a key indicator of a company's ability to pay its current liabilities. It's calculated by dividing the total amount of current assets by the total amount of current liabilities.
A larger current ratio generally indicates a company is more likely to pay its current liabilities on time. However, the ideal current ratio varies depending on factors such as the type of business, size, and industry.
For example, a large manufacturing corporation like ABC may have a current ratio of 1.05, which seems small, but is still a good indicator of its ability to pay its current liabilities. On the other hand, a small internet business like Beta Company may operate with a current ratio of 1.75, which is acceptable given its high daily sales and prompt payment from customers.
The debt to total assets ratio is another important financial ratio that indicates the percentage of a company's assets financed by debt. A lower ratio is generally considered better, as it indicates less risk for lenders and the company.
Here are some examples of debt to total assets ratios from two companies:
These ratios can provide valuable insights into a company's financial health and ability to manage its debt.
Profitability Ratios
Profitability ratios measure a company's ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the gross margin ratio, operating margin ratio, return on assets ratio, and return on equity ratio.
The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold. For example, Home Depot has a 33.39% gross profit margin, while Walmart's is 25.11%.
The operating margin ratio measures how efficiently a company is using its assets to generate profit. It's calculated by dividing operating income by net sales. Companies use this ratio to determine how much profit they generate from net sales after accounting for the cost of goods sold and operating expenses.
The return on assets (ROA) ratio measures how efficiently a company is using its assets to generate profit. It's calculated by dividing net income by total assets. Companies use this ratio to determine how much profits they generate from total assets or resources, including current and noncurrent assets.
The return on equity (ROE) ratio measures how efficiently a company is using its equity to generate profit. It's calculated by dividing net income by shareholder's equity. For instance, a company with a declining ROE could be seen as having more risk than a company in the same industry with an increasing ROE.
Here are some common profitability ratios:
- Gross Margin Ratio: Gross profit / Net sales
- Operating Margin Ratio: Operating income / Net sales
- Return on Assets (ROA) Ratio: Net income / Total assets
- Return on Equity (ROE) Ratio: Net income / Shareholder's equity
Note: A good profit margin ratio varies by industry, so it's helpful to benchmark your results against your competitors using a database of profit margins by sector.
Efficiency Ratios
Efficiency ratios are used to measure how well a company is utilizing its assets and resources. They help businesses identify areas for improvement and make data-driven decisions.
The asset turnover ratio measures a company's ability to generate sales from assets. It's calculated by dividing net sales by average total assets. A higher ratio indicates that a company is using its assets more efficiently.
A company's efficiency ratio can also be measured by its inventory turnover ratio, which shows how many times a company's inventory is sold and replaced over a given period. This ratio is calculated by dividing cost of goods sold by average inventory.
Here are some common efficiency ratios and their formulas:
- Asset Turnover Ratio: Net Sales / Average Total Assets
- Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory
- Days Sales in Inventory Ratio: 365 days / Inventory Turnover Ratio
These ratios can help businesses determine whether they're holding inventory for too long, paying suppliers too quickly, or generating sales from assets efficiently. By analyzing these ratios, companies can identify areas for improvement and make changes to increase their efficiency and profitability.
Efficiency
Efficiency ratios are a powerful tool to measure how well a company is utilizing its assets and resources. They help businesses identify areas for improvement and optimize their operations to achieve better financial performance.
A high asset turnover ratio indicates that a company is generating a lot of sales from its assets. For instance, a company with an asset turnover ratio of 3 means it generates $3 in sales for every dollar of assets. This is a sign of efficient asset utilization.
Inventory turnover is crucial for companies in the manufacturing and production industries, as it measures how often inventory is used and replaced for operations. A high inventory turnover ratio indicates that a company is selling its inventory quickly and efficiently.
The days sales in inventory ratio calculates how long a business holds inventories before they are converted to finished products or sold to customers. A low days sales in inventory ratio indicates that a company is selling its inventory quickly, which can lead to increased cash flow and reduced inventory costs.
Payables turnover ratio calculates how quickly a business pays its suppliers and creditors. A high payables turnover ratio indicates that a company is paying its suppliers quickly, which can lead to better relationships with suppliers and improved cash flow.
The payables turnover ratio is often used in conjunction with the days payables outstanding (DPO) ratio, which shows how many days it takes a company to pay off suppliers and vendors. A low DPO ratio indicates that a company is paying its suppliers quickly, which can lead to improved relationships and reduced costs.
Receivables turnover ratio helps companies measure how quickly they turn customers' invoices into cash. A high receivables turnover ratio indicates that a company is collecting its accounts receivable quickly, which can lead to improved cash flow and reduced bad debt expenses.
A high efficiency ratio, such as Washington Federal's 55.7% efficiency ratio, indicates improved profitability and efficient use of working capital. This can be a sign of a company's ability to generate sales from its assets and optimize its operations for better financial performance.
Quick Ratio
The quick ratio, also known as the acid test, is a measure of a company's ability to pay its current liabilities with its most liquid assets. This ratio is more conservative than the current ratio because it excludes inventory and prepaid expenses, which may not be easily converted to cash.
A quick ratio of less than 1 can indicate that a company may not have enough liquid assets to pay its short-term liabilities. This can be a temporary situation or a sign of a more serious issue that needs to be addressed.
The quick ratio is calculated by dividing the company's quick assets (cash, cash equivalents, temporary investments, and accounts receivable) by its current liabilities. Quick assets are those that can be quickly converted to cash to pay off debts.
For example, if a company has $1,600,000 in quick assets and $4,000,000 in current liabilities, its quick ratio would be 0.40. This means that the company may need to sell its inventory items quickly to collect the cash needed to pay its current liabilities.
Here are some general guidelines for interpreting quick ratios:
- A quick ratio of 1 or higher indicates that a company has enough liquid assets to cover its short-term obligations.
- A quick ratio of less than 1 may indicate that a company is at risk of not being able to pay its short-term liabilities.
- The quick ratio can vary depending on factors such as the makeup of the quick assets, how fast customers pay for the goods or services provided by the company, and the dates that the current liabilities must be paid.
In some cases, a company's quick ratio may be lower than its current ratio, especially if it has a lot of inventory or prepaid expenses. However, a lower quick ratio can still be a concern if it indicates that the company may not have enough liquid assets to pay its debts.
Inventory Turnover
The inventory turnover ratio is a key efficiency ratio that measures how efficiently a company manages its inventory. It indicates the speed at which a company sells its inventory of goods.
The formula for calculating the inventory turnover ratio is: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory. This ratio is an average of perhaps hundreds of different products and component parts carried in inventory.
A high inventory turnover ratio is generally preferred, as it indicates that a company is selling its inventory quickly and efficiently. However, it's also important to ensure that a company's inventory levels are not too low, as this can lead to stockouts and lost sales.
To calculate the inventory turnover ratio, you'll need to know the cost of goods sold for the year and the average inventory cost during the year. The average inventory cost is typically calculated by taking the average of the inventory cost at the beginning and end of the year.
Here's an example of how to calculate the inventory turnover ratio: Assume a company has a cost of goods sold of $280,000 and an average inventory cost of $70,000. The inventory turnover ratio would be $280,000 / $70,000 = 4 times in the year.
A good inventory turnover ratio can vary depending on the industry and company, but as a general rule, a ratio of 4-6 times per year is considered good. If your company's inventory turnover ratio is lower than this, it may indicate that you're carrying too much inventory or that your sales are poor.
Here are some general guidelines for interpreting inventory turnover ratios:
- 4-6 times per year: Good
- 2-3 times per year: Fair
- Less than 2 times per year: Poor
Keep in mind that these are general guidelines, and the best inventory turnover ratio for your company will depend on your specific business needs and industry.
Frequently Asked Questions
What are the top 5 financial ratios?
The top 5 financial ratios are key metrics that help investors and analysts assess a company's liquidity, profitability, and efficiency. They include the Quick Ratio, Return on Equity (ROE) ratio, Profit Margin, Earnings Per Share (EPS), and Price to Earnings (P/E) ratio.
What are the 5 major categories of ratios?
There are five major categories of ratios used in financial analysis: liquidity, leverage, efficiency, profitability, and market value ratios. Understanding these categories can help investors and analysts make informed decisions about a company's financial health and potential for growth.
Sources
- https://corporatefinanceinstitute.com/resources/accounting/financial-ratios/
- https://www.investopedia.com/financial-edge/0910/6-basic-financial-ratios-and-what-they-tell-you.aspx
- https://www.datarails.com/5-key-financial-ratios/
- https://www.accountingcoach.com/financial-ratios/explanation
- https://www.bench.co/blog/accounting/most-important-financial-ratios
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