Financial ratios are a relatively easy way to get a basic understanding of the financial health of an organisation and to work out your business’ financial weaknesses and strengths. They also offer a view of your business’s competitive performance in relation to similar businesses in your industry.

This article is not meant to be a comprehensive lesson in financial ratio analysis, but rather an introduction to some of the most pervasive, and arguably most important, ratios.

Liquidity

These ratios analyse the available liquid assets your business has at any given time to meet current liabilities. In other words, it tells you how much cash-on-hand you have, as well as assets that can readily be turned into cash. This lets you know how much money is accessible if needed to pay your liabilities or debts.

A good rule of thumb is the greater your liquidity, the better. However, bear in mind, the higher the liquidity ratio, the greater the proportion of resources tied up in relatively non-productive assets.

This may have an adverse effect on earnings. It is necessary, therefore, to aim to achieve a balance between earnings and liquidity.

1) The Quick Ratio (Acid Test Ratio) helps answer the question: “If all sales revenues should disappear, could my business meet its current obligations with the readily convertible 'quick' funds on hand?" . It is a very stringent test, but for companies which have large and liquid inventories it may not be the most appropriate. All else equal, a higher quick ratio indicates a healthier company.

Quick Ratio = (Cash + Accounts Receivable + Short Term Investments) / Current Liabilities

An acid-test of 1:1 (ie for every $1 of current liability you have $1 of “quick assets”) is considered satisfactory unless the majority of your quick assets are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.

2) The Current Ratio is similar to the Quick Ratio, except that it includes all short term assets. The current ratio is the most commonly used measure of liquidity; it gives an indication of the efficiency of a company’s operating cycle and how well it turns products into cash. If current liabilities exceed current assets the company is likely to experience inefficiencies associated with financial distress. The higher the ratio indicates a healthier company.

Current Ratio = Current Assets / Current Liabilities

Example:

Say your current assets are $500,000 and your current liabilities are $400,000. Your current ratio would therefore be 1.25:1

This means for every dollar you owe you have $1.25 available in current assets. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable.

3) The Interest Coverage Ratio indicates the ease with which an organisation can meet its interest payment obligations from cash flows. This ratio is commonly found in debt covenants and is a good indication of the likelihood of financial distress. It is also one measure of the leverage of the company, the lower the ratio the greater the debt burden of the company.

Interest Coverage = EBIT / Interest Expense

EBIT is the common term for earnings before interest and tax. Sometimes EBITDA is used in its place which includes depreciation and amortisation. In other words, EBITDA measures earnings from operating activities.

As a general guide a ratio of 2:1 indicates a good interest cover position. Whilst a ratio of below 1:1 indicates that earnings are insufficient to cover ongoing finance expenses.

Performance

Making money is what being in business is all about and various performance ratios will help show how successful your business is. The performance ratios explained below are high level indicators of a company’s performance. It is vital to take into account company characteristics before basing decisions on any of these ratios.

1) Gross Profit Margin (GP) calculates the average profit per dollar of sales before operating expenses.

GP Margin = Gross Profit/Sales

Example

If gross profit was $190,000 and total sales were $650,000 then your gross profit margin would be 29%.

The ‘ideal’ percentage can vary dramatically between industries, so you might want to benchmark your performance against others in your industry. If you find that your gross profit margin is low, it is likely your income is below expectations or your direct costs are too high, and you may need to think of strategies to boost your sales or reduce costs.

2) Return on Assets (ROA) is one of the core performance ratios. It indicates how efficiently a company is using it’s assets to generate earnings. This figure varies greatly between companies for a range of reasons. A higher ratio indicates a more profitable company.

ROA = Net Profit before Tax / Total Assets

Return on assets is useful as it allows you to gauge what sort of return you are getting as a result of all your hard work. A figure in excess of 10% is considered good.

Efficiency Ratios

If your assets are being used to their best, you would expect that the return on your assets should also be at a maximum.

One way of assessing this is to measure their frequency of turnover, such as asset turnover. You can measure this with the following ratios and use them to track improvements.

1) The Asset Turnover Ratio can be calculated as follows:

Asset Turnover = Sales/Total Assets

Example

If your sales were $120,000 and you had total assets of $50,000 then your asset turnover is 2.4 times. Obviously the higher the asset turnover, the better use of you assets.

2) The Inventory Turnover Ratio gives an indication of how quickly inventory is sold. With a move towards just-in-time purchasing and production, low inventory turnover is increasingly becoming unacceptable as it represents high overheads (insurance, storage etc) as well as increasing the chances of spoilage and obsolescence.

Inventory Turnover = Cost of Goods Sold / Average Inventory

3) The Collection Ratio can be an important measure of financial health, especially for companies with a low current ratio. It is the average number of days that it takes for the company to receive payment for its goods or services.

Collection Ratio = Accounts Receivable / (Revenue/ 365)

This ratio is useful for business whose customers may be on 14 or 30 day credit terms. It’s an ‘overall’ picture, so it does not tell us about individual accounts. To do this it is necessary to age them separately. Most accounting software products are able to perform this function.

If the average collection period is high or growing, then this is a clear signal that you need to take action to collect your debtors quicker.

If the average collection period is low, you might consider extending more credit in an effort to stimulate greater sales. Some customers rely on credit, so a tight credit policy can sometimes hurt your business. However, it is obviously far better to have a short collection period.

Summary

Ratios provide a great deal of information and we have provided an insight into some of the more commonly used ratios here. However, they do have limitations and it should not be assumed that ratio analysis will tell you everything you need to know about your business’ financial performance.

Additionally, if you make comparisons with other businesses in your industry, keep in mind not all businesses are the same. Ratios are usually comparisons with industry averages, however your business will not, and should not be, exactly the same as others in your industry.