Financial Ratios

Financial ratios are quantitative measures used to assess the performance and the overall financial health of a business. The end goal of using ratio analysis is to improve the decision making process. Ratio analysis not only compares similar companies against each other, but also can be used to track the performance of a company year to year.

The following ratio definitions are broken down into five categories: cash flow-solvency; profitability; efficiency; leverage and growth. Growth calculations are available in the downloadable spreadsheet. Growth measure performance either year to year or over a multi-year period. When we calculate growth over a multi-year period we typically use a compound growth calculation.

Our article on the use of financial ratios can be read here on our newsletter page.

The spreadsheet for the following ratios will be available soon. Come back here for further information.

Cash Flow-Solvency

Current Ratio This is the same as Current Assets/Current Liabilities, measuring current assets available to cover current liabilities, a test of near-term solvency. The ratio indicates to what extent cash on hand and disposable assets are enough to pay off near term liabilities. The Quick Ratio is applied as a more stringent test.
Quick Ratio (Cash plus Accounts Receivable)/Current Liabilities, indicating liquid assets available to cover current debt. Also known as the Acid Ratio. This is a harsher version of the Current Ratio, which balances short-term liabilities against cash and liquid instruments.

 

Profitability

Gross Margin Pre-tax Gross Profit/Annual Business Revenue. This is the profit ratio before product and Business Revenue costs, as well as taxes. This ratio can indicate the “play” in other expenses which could be adjusted to increase the Net Profit margin.
EBITDA Margin Earnings Before Interest, (income) Taxes due, Depreciation and Amortization/Business Revenue. EBITDA: Business Revenue is a relatively controversial (and often criticized) metric designed to eliminate the effect of finance and accounting decisions when comparing companies and industry benchmarks. Tax credits and deferral procedures and non-cash expenditures (Amortization and Depreciation) are not deducted from the profit equation, as are interest expenditures.
EBIT Margin EBIT Margin Earnings Before Interest and (income) Taxes due. EBIT: Business Revenue measures operating profit before the effects of taxation and financing.
Return on Assets (pre-tax) Pre-Tax or After Tax Net Profit/Total Assets, a critical indicator of profitability. Companies which use their assets efficiently will tend to show a ratio higher than the industry norm. The ratio may appear higher for small businesses due to owner compensation draws accounted as net profit.
Return on Equity  (pre-tax) Pre-Tax or After Tax Net Profit/Net Worth. This is the ‘final measure’ of profitability to evaluate overall return. This ratio measures return relative to investment, how well a company leverages the investment in it. May appear higher for small businesses due to owner compensation draws accounted as net profit.
Net Profit Margin (pre-tax) Pre-Tax or After Tax Net Profit Net Profit/Annual Business Revenue, indicating the level of profit from each dollar of Business Revenue. This ratio can be used as a predictor of the company’s ability to withstand changes in prices or market conditions. May appear higher for small businesses due to owner compensation draws accounted as net profit.

 

Efficiency

Fixed Asset Turnover Business Revenue/Fixed Assets. An indicator of the efficiency of investment in fixed asset such as plant and equipment. Target at or slightly below industry level.
Inventory Turnover (Days) 365/(Cost of Sales: Inventory): The average number of days of items in inventory.
Days Sales Outstanding 365/(Business Revenue/Receivables): Reflects the number of days that receivables are outstanding. Target average or lower.
Days Payable Outstanding 365/(Cost of Sales: Accounts Payable ratio): Reflects the average number of days for each payable before payment is made.

 

Leverage Ratios

Interest Coverage EBITDA/Interest Expense: Earnings before Interest, (income) Taxes due, Depreciation and Amortization divided by Interest expense. Assesses financial stability by examining whether a company is at least profitable enough to pay interest expense. A ratio >1.00 indicates it is. See cautions in the listing for EBITDA.
Total Debt: Net Worth Total Debt/Net Worth, a measure of coverage of all debt compared to owner’s equity.
Total Debt: Total Capital The total amount of debt in the capital structure of the company. The capital of the company is the addition of all debt (including capital leases) and owner’s equity. High ratios relative to the industry can indicate low working capital or high levels of debt.