Financial ratios are the most common and widespread tools used to analyse a business’s or organisation’s financial standing. They are used as indicators to help business owners and key management to:
- Identify potential problems and trends within your firm;
- Inform you about factors such as the earning power, solvency, efficiency and debt load of your firm;
- Understand how well your firm is performing and the areas needing improvement;
- Evaluate the performance of your firm; and
- Compare your firm’s financials to those of your competitors.
Financial ratios are normally classified according to the information they can provide you with. For example:
- Leverage ratios
- Liquidity ratios
- Asset turnover ratios
- Profit margin ratios
- Dividend payout ratio
This article is prepared to help you quickly and easily understand some of the most common financial ratios that should be used by business owners and key management to help them understand how well their business or organisation is performing.
Leverage ratios provide an indication of your business’s or organisation’s long‑term solvency and to what extent you are using long-term debt to support your business or organisation. Two frequently-used leverage ratios are the debt-to-asset ratio and the debt-to-equity ratio.
Basically, the debt-to-asset ratio illustrates how your business or organisation has grown and acquired its assets over time.
The debt-to-asset ratio formula is calculated by dividing total liabilities by total assets.
Total Liabilities Debt-to- Asset Ratio = --------------------- Total Assets
The debt-to-asset ratio measurement test is used by analysts to evaluate the overall risk of a firm. Businesses or organisations with a higher figure are considered riskier to invest in and loan to because they are more leveraged. Thus lower is always better.
The debt- to-equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet.
The debt-to-equity ratio is calculated by dividing total liabilities by total shareholder equity.
Total Liabilities Debt-To-Equity Ratio = ---------------------------------- Total Shareholder Equity
A lower debt- to-equity ratio usually implies a more financially stable business. Firms that have a higher debt- to-equity ratio are generally considered riskier to creditors and investors than those with a lower ratio.
Liquidity ratios measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts and provide a broad overview of your financial health. Two frequently-used liquidity ratios are the quick ratio and the current ratio.
The quick ratio (also called cash ratio or acid test ratio). Indicates your business’s or organisation’s ability to meet immediate creditor demands, using its most liquid assets (cash or assets that are easily converted into cash), also called quick assets.
The quick ratio is calculated by subtracting inventory from the current assets total and then dividing the numerator by current liabilities
Current Assets - Inventory Quick Ratio = ----------------------------------- Current Liabilities
The quick ratio test measures the liquidity of a firm by showing its ability to pay off its current liabilities with quick assets
The current ratio also called (working capital ratio). Indicates whether your business or organisation has sufficient cash flow to meet its short‑term obligations, take advantage of opportunities and attract favourable credit terms.
The current ratio is calculated by dividing current assets by current liabilities.
Current Assets Current Ratio = ------------------------ Current Liabilities
The current ratio will shed some light on the overall debt burden of your firm. If your firm is weighted down with a current debt, then its cash flow will suffer.
Asset Turnover Ratio
The asset turnover ratio is an efficiency ratio that will show you how efficiently your business or organisation can use its assets to generate sales.
The asset turnover ratio is calculated by dividing net sales by average total assets.
Net Sales Asset Turnover Ratio = ------------------------ Average Total Assets
This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always more favourable.
Profit Margin Ratio
The profit margin ratio also called the return on sales ratio or gross profit ratio is a profitability ratio that measures the amount of net income earned for each dollar of sales generated by comparing the net income and net sales of a firm.
This ratio is often used by internal management to set performance goals for the future.
The profit margin ratio formula can be calculated by dividing net income by net sales.
Net Income Profit Margin Ratio = ----------------- Net Sales
The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.
Dividend Payout Ratio
The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the firm decides to keep to fund operations and the portion of profits that is given to its shareholders.
The dividend payout formula is calculated by dividing total dividend by the net income of the business or organisation.
Total Dividend Dividend Payout Ratio = ----------------- Net Income
The dividend payout ratio analysis is important to investors who want to see a steady stream of sustainable dividends from a company. A consistent trend in this ratio is usually more important than a high or low ratio.
Seek Expert and Professional Advice
Employing the services of our expert business and management consultant will benefit you. In so much as our business and management consultant is also a professionally qualified public accountant.
It is important that you seek advice from someone who is suitably qualified to give you professional advice. It is, for this reason, that you should seek advice from our business and management consultant who has the required knowledge and understanding of explaining to you, how using financial ratios can benefit your firm’s performance and financial situation.
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