Reviewing and understanding financial statements can be difficult, even for trained financial analysts. Financial documents can be long and confusing. Sometimes they are confusing on purpose because the analysts who created them may want to hide information.
That’s where the power of ratios comes into play. Ratios show the relationship of one number to another. Financial ratios measure a company’s financials to provide clear insight of performance.
I like to relate ratios to pivot tables or graphs used to display clarity for data. If you have a spreadsheet filled with data, it would be difficult to see a clear picture of what the numbers mean. If that same data goes into a pivot table or graph, you will have a much better understanding of what the data is telling you.
Below is some insight into commonly used financial ratios:
Profitability Ratios
Profitability ratios are the most commonly used ratios and they display whether a company can generate profits. This is, how well a company is able to take in more money than it spends. There are a lot of different profitably ratios, below are just a couple:
Gross Profit Margin Percentage – The gross profit margin percentage is the gross profit divided by revenue. The result is then shown as a percentage like below”
Gross Margin = gross profit/Revenue
Return on Assets – ROA will show what was returned to the business as a profit from every dollar invested. The formula is net profit divided by total assets.
ROA = Net Profit/Total Assets
Leverage Ratios
Leverage refers to debt and leverage ratios are used to show if the company is making or losing money used by its debt. Below are two commonly used financial leverage ratios:
Debt-to-Equity – The debt to equity ratio shows how much debt the company has for each dollar of shareholder equity. The formula is total liabilities divided by share holder equity.
Debt to Equity = Total Liabilities/Share Holder Equity
Interest Covered – This ratio shows how much interest a company has to pay related to how much the company is making. The formula is operating profit divided by annual interest charges.
Interest Covered = Operating Profit/Annual interest charges
Liquidity Ratios
Liquidity ratios are important, particularly to small businesses. They show whether a company has enough money available to pay for its bills and “keep the lights on”. Below are two commonly used liquidity ratios
Current Ratio – This ratio measures the current assets against the current liabilities. The formula is current assets divided by current liabilities:
Current Ratio = Current Assets/Current Liabilities
Quick Ratio – The quick ratio shows how fast a company would be able to pay off its short term debt by measuring its current assets, minus inventory, against its current liabilities. The formula is current assets minus current inventory divided by current liabilities.
Quick Ratio = Current Assets – Current Inventory/Current Liabilities
Efficiency Ratios
Efficiency ratios can show how well a company manages its balance sheet assets and liabilities. The bottom line of these ratios is how long it takes to turn expenses into cash. Below is a couple of the key efficiency ratios used:
Days in inventory (DII) – This ratio measures how many days inventory will stay in a company’s system. The formula is average inventory divided by Cost of goods sold divided by day, see below:
DII = Average Inventory divided by (COGS/day)
Days Sales Outstanding (DSO) – this ratio shows how fast customers pay their bills or how fast it takes to collect cash for the sales. The formula is accounts receivable (from the end of the pay period) divided by revenue per day:
DSO = ending A/R / (Revenue/day)
For more content like this, subscribe to the MacIsaac Consulting Blog.
Follow Mike on Twitter @MikeMacIsaac
To contact us about our services, click here.