business plan ratio analysis

How to Use These Common Business Ratios

2 min. read

Updated October 27, 2023

What business ratios should you know and be using? Here’s a breakdown of common ratios, how they’re used, and in some cases how you’ll calculate them.

Main ratios

• Current. Measures company’s ability to meet financial obligations. Expressed as the number of times current assets exceed current liabilities. A high ratio indicates that a company can pay its creditors. A number less than one indicates potential cash flow problems.
• Quick. This ratio is very similar to the Acid Test (see below), and measures a company’s ability to meet its current obligations using its most liquid assets. It shows Total Current Assets excluding Inventory divided by Total Current Liabilities.
• Total Debt to Total Assets. Percentage of Total Assets financed with debt.
• Pre-Tax Return on Net Worth. Indicates shareholders’ earnings before taxes for each dollar invested. This ratio is not applicable if the subject company’s net worth for the period being analyzed has a negative value.
• Pre-Tax Return on Assets. Indicates profit as a percentage of Total Assets before taxes. Measures a company’s ability to manage and allocate resources.

Additional ratios

• Net Profit Margin. This ratio is calculated by dividing Sales into the Net Profit, expressed as a percentage.
• Return on Equity. This ratio is calculated by dividing Net Profit by Net Worth, expressed as a percentage.

Activity ratios

• Accounts Receivable Turnover. This ratio is calculated by dividing Sales on Credit by Accounts Receivable. This is a measure of how well your business collects its debts.
• Collection Days. This ratio is calculated by multiplying Accounts Receivable by 360, which is then divided by annual Sales on Credit. Generally, 30 days is exceptionally good, 60 days is bothersome, and 90 days or more is a real problem.
• Inventory Turnover. This ratio is calculated by dividing the Cost of Sales by the average Inventory balance.
• Accounts Payable Turnover. This ratio is a measure of how quickly the business pays its bills. It divides the total new Accounts Payable for the year by the average Accounts Payable balance.
• Payment Days. This ratio is calculated by multiplying average Accounts Payable by 360, which is then divided by new Accounts Payable.
• Total Asset Turnover. This ratio is calculated by dividing Sales by Total Assets.

Debt ratios

• Debt to Net Worth. This ratio is calculated by dividing Total Liabilities by total Net Worth.
• Current Liab. to Liab. This ratio is calculated by dividing Current Liabilities by Total Liabilities.

Liquidity ratios

• Net Working Capital. This ratio is calculated by subtracting Current Liabilities from Current Assets. This is another measure of cash position.
• Interest Coverage. This ratio is calculated by dividing Profits Before Interest and Taxes by total Interest Expense.
• Assets to Sales. This ratio is calculated by dividing Assets by Sales.
• Current Debt/Total Assets. This ratio is calculated by dividing Current Liabilities by Total Assets.
• Acid Test. This ratio is calculated by dividing Current Assets (excluding Inventory and Accounts Receivable) by Current Liabilities.
• Sales/Net Worth. This ratio is calculated by dividing Total Sales by Net Worth.
• Dividend Payout. This ratio is calculated by dividing Dividends by Net Profit.

In the real world, financial profile information involves some compromise. Very few organizations fit any one profile exactly. Variations, such as doing several types of business under one roof, are quite common. If you cannot find a classification that fits your business exactly, use the closest one and explain in your text how and why your business is different from the standard.

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Tim Berry is the founder and chairman of Palo Alto Software , a co-founder of Borland International, and a recognized expert in business planning. He has an MBA from Stanford and degrees with honors from the University of Oregon and the University of Notre Dame. Today, Tim dedicates most of his time to blogging, teaching and evangelizing for business planning.

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Financial Ratio Analysis Tutorial With Examples

The Balance Sheet for Financial Ratio Analysis

The income statement for financial ratio analysis, analyzing the liquidity ratios, the current ratio, the quick ratio, analyzing the asset management ratios accounts receivable, receivables turnover, average collection period, inventory, fixed assets, total assets, inventory turnover ratio, fixed asset turnover, total asset turnover, analyzing the debt management ratios, debt-to-asset ratio, times interest earned ratio, fixed charge coverage, analyzing the profitability ratios, net profit margin, return on assets, return on equity, financial ratio analysis of xyz corporation.

While it may be more fun to work on marketing efforts, the financial management of a firm is a crucial aspect of owning a business. Financial ratios help break down complex financial information into key details and relationships. Financial ratio analysis involves studying these ratios to learn about the company's financial health.

Here are a few of the most important financial ratios for business owners to learn, what they tell you about the company's financial statements, and how to use them.

Key Takeaways

• Some of the most important financial ratios for business owners include the current ratio, the inventory turnover ratio, and the debt-to-asset ratio.
• These financial ratios quickly break down the complex information from financial statements .
• Financial ratios are snapshots, so it's important to compare the information to previous periods of data as well as competitors in the industry.

Here is the balance sheet we are going to use for our financial ratio tutorial. You will notice there are two years of data for this company so we can do a time-series (or trend) analysis and see how the firm is doing across time.

Here is the complete income statement for the firm for which we are doing financial ratio analysis. We are doing two years of financial ratio analysis for the firm so we can compare them.

Refer back to the income statement and balance sheet as you work through the tutorial.

The first ratios to use to start getting a financial picture of your firm measure your liquidity, or your ability to convert your current assets to cash quickly. They are two of the 13 ratios. Let's look at the current ratio and the quick (acid-test) ratio .

The current ratio measures how many times you can cover your current liabilities. The quick ratio measures how many times you can cover your current liabilities without selling any inventory and so is a more stringent measure of liquidity.

Remember that we are doing a time series analysis, so we will be calculating the ratios for each year.

Current Ratio : For 2022, take the Total Current Assets and divide them by the Total Current Liabilities. You will have: Current Ratio = 642/543 = 1.18X. This means that the company can pay for its current liabilities 1.18 times over. Practice calculating the current ratio for 2023.

Your answer for 2023 should be 1.31X. A quick analysis of the current ratio will tell you that the company's liquidity has gotten just a little bit better between 2022 and 2023 since it rose from 1.18X to 1.31X.

Quick Ratio : In order to calculate the quick ratio, take the Total Current Ratio for 2022 and subtract out Inventory. Divide the result by Total Current Liabilities. You will have: Quick Ratio = (642-393)/543 = 0.46X. For 2023, the answer is 0.52X.

Like the current ratio, the quick ratio is rising and is a little better in 2023 than in 2022. The firm's liquidity is getting a little better. The problem for this company, however, is that they have to sell inventory to pay their short-term liabilities and that is not a good position for any firm to be in. This is true in both 2022 and 2023.

This firm has two sources of current liabilities: accounts payable and notes payable. They have bills that they owe to their suppliers (accounts payable) plus they apparently have a bank loan or a loan from some alternative source of financing. We don't know how often they have to make a payment on the note.

Asset management ratios are the next group of financial ratios that should be analyzed. They tell the business owner how efficiently they employ their assets to generate sales. Assume all sales are on credit.

• Receivables Turnover = Credit Sales/Accounts Receivable
• Receivables Turnover = 2,311/165 = 14X

A receivables turnover of 14X in 2022 means that all accounts receivable are cleaned up (paid off) 14 times during the 2022 year. For 2023, the receivables turnover is 15.28X. Look at 2022 and 2023 Sales in The Income Statement and Accounts Receivable in The Balance Sheet.

The receivables turnover is rising from 2022 to 2023. We can't tell if this is good or bad. We would really need to know what type of industry this firm is in and get some industry data to compare to.

Customers paying off receivables is, of course, good. But, if the receivables turnover is way above the industry's, then the firm's credit policy may be too restrictive.

The average collection period is also about accounts receivable. It is the number of days, on average, that it takes a firm's customers to pay their credit accounts. Together with receivables turnover, the average collection helps the firm develop its credit and collections policy.

• Average Collection Period = Accounts Receivable/Average Daily Credit Sales
• To arrive at average daily credit sales, take credit sales and divide by 360
• Average Collection Period = $165/2,311/360 = $165/6.42 = 25.7 days
• In 2023, the average collection period is 23.5 days

From 2022 to 2023, the average collection period is dropping. In other words, customers are paying their bills more quickly. Compare that to the receivables turnover ratio. Receivables turnover is rising and the average collection period is falling.

This makes sense because customers are paying their bills faster. The company needs to compare these two ratios to industry averages. In addition, the company should take a look at its credit and collections policies to be sure they are not too restrictive. Take a look at the image above and you can see where the numbers came from on the balance sheets and income statements.

Along with the accounts receivable ratios that we analyzed above, we also have to analyze how efficiently we generate sales with our other assets: inventory, plant and equipment, and our total asset base.

The inventory turnover ratio is one of the most important ratios a business owner can calculate and analyze. If your business sells products as opposed to services, then inventory is an important part of your equation for success.

Inventory Turnover = Sales/Inventory

If your inventory turnover is rising, that means you are selling your products faster. If it is falling, you are in danger of holding obsolete inventory. A business owner has to find the optimal inventory turnover ratio where the ratio is not too high and there are no stockouts or too low where there is obsolete money. Both are costly to the firm.

For this company, their inventory turnover ratio for 2022 is:

Inventory Turnover Ratio = Sales/Inventory = 2,311/393 = 5.9X

This means that this company completely sells and replaces its inventory 5.9 times every year. In 2023, the inventory turnover ratio is 6.8X. The firm's inventory turnover is rising. This is good in that they are selling more products. The business owner should compare the inventory turnover with the inventory turnover ratio of other firms in the same industry.

The fixed asset turnover ratio analyzes how well a business uses its plant and equipment to generate sales. A business firm does not want to have either too little or too much plant and equipment. For this firm for 2022:

Fixed Asset Turnover = Sales/Fixed Assets = 2,311/2,731 = 0.85X

For 2023, the fixed asset turnover is 1.00. The fixed asset turnover ratio is dragging down this company. They are not using their plant and equipment efficiently to generate sales as, in both years, fixed asset turnover is very low.

The total asset turnover ratio sums up all the other asset management ratios. If there are problems with any of the other total assets, it will show up here, in the total asset turnover ratio.

Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets = 2,311/3,373 = 0.69X for 2022. For 2023, the total asset turnover is 0.80. The total asset turnover ratio is somewhat concerning since it was not even 1X for either year.

This means that it was not very efficient. In other words, the total asset base was not very efficient in generating sales for this firm in 2022 or 2023. Why?

It seems that most of the problem lies in the firm's fixed assets. They have too much plant and equipment for their level of sales. They either need to find a way to increase their sales or sell off some of their plant and equipment. The fixed asset turnover ratio is dragging down the total asset turnover ratio and the firm's asset management in general.

There are three debt management ratios that help a business owner evaluate the company in light of its asset base and earning power. Those ratios are the debt-to-asset ratio, the times interest earned ratio , and the fixed charge coverage ratios. Other debt management ratios exist, but these help give business owners the first look at the debt position of the company and the prudence of that debt position.

The first debt ratio that is important for the business owner to understand is the debt-to-asset ratio ; in other words, how much of the total asset base of the firm is financed using debt financing. For example. the debt-to-asset ratio for 2022 is:

Total Liabilities/Total Assets = $1,074/3,373 = 31.8%. This means that 31.8% of the firm's assets are financed with debt. In 2023, the debt ratio is 27.8%. In 2023, the business is using more equity financing than debt financing to operate the company.

We don't know if this is good or bad since we do not know the debt-to-asset ratio for firms in this company's industry. However, we do know that the company has a problem with its fixed asset ratio which may be affecting the debt-to-asset ratio.

The times interest earned ratio tells a company how many times over a firm can pay the interest that it owes. Usually, the more times a firm can pay its interest expense the better. The times interest earned ratio for this firm for 2022 is:

• Times Interest Earned = Earnings Before Interest and Taxes/Interest = 276/141 = 1.96X
• For 2023, the times interest earned ratio is 3.35

The times interest earned ratio is very low in 2022 but better in 2023. This is because the debt-to-asset ratio dropped in 2023.

The fixed charge coverage ratio is very helpful for any company that has any fixed expenses they have to pay. One fixed charge (expense) is interest payments on debt, but that is covered by the times interest earned ratio.

Another fixed charge would be lease payments if the company leases any equipment, a building, land, or anything of that nature. Larger companies have other fixed charges which can be taken into account.

• Fixed charge coverage = Earnings Before Fixed Charges and Taxes/Fixed Charges

In both 2022 and 2023 for the company in our example, its only fixed charge is interest payments. So, the fixed charge coverage ratio and the times interest earned ratio would be exactly the same for each year for each ratio.

The last group of financial ratios that business owners usually tackle are the profitability ratios as they are the summary ratios of the 13 ratio group. They tell the business firm how they are doing on cost control, efficient use of assets, and debt management, which are three crucial areas of the business.

The net profit margin measures how much each dollar of sales contributes to profit and how much is used to pay expenses. For example, if a company has a net profit margin of 5%, this means that 5 cents of every sales dollar it takes in goes to profit and 95 cents goes to expenses. For 2022, here is XYZ, Inc.'s net profit margin:

Net Profit Margin = Net Income/Sales Revenue = 89.1/2,311 = 3.9%

For 2023, the net profit margin is 6.5%, so there was quite an increase in their net profit margin. You can see that their sales took quite a jump but their cost of goods sold rose. It is the best of both worlds when sales rise and costs fall. Bear in mind: The company can still have problems even if this is the case.

The return on assets ratio, also called return on investment , relates to the firm's asset base and what kind of return they are getting on their investment in their assets. Look at the total asset turnover ratio and the return on asset ratio together. If total asset turnover is low, the return on assets is going to be low because the company is not efficiently using its assets.

Another way to look at the return on assets is in the context of the Dupont method of financial analysis. This method of analysis shows you how to look at the return on assets in the context of both the net profit margin and the total asset turnover ratio.

• To calculate the Return on Assets ratio for XYZ, Inc. for 2022, here's the formula:
• Return on Assets = Net Income/Total Assets = 2.6%

For 2023, the ROA is 5.2%. The increased return on assets in 2023 reflects the increased sales and much higher net income for that year.

The return on equity ratio is the one of most interest to the shareholders or investors in the firm. This ratio tells the business owner and the investors how much income per dollar of their investment the business is earning. This ratio can also be analyzed by using the Dupont method of financial ratio analysis. The company's return on equity for 2022 was:

Return on Equity = Net Income/Shareholder's Equity = 3.9%

For 2023, the return on equity was 7.2%. One reason for the increased return on equity was the increase in net income. When analyzing the return on equity ratio, the business owner also has to take into consideration how much of the firm is financed using debt and how much of the firm is financed using equity.

Now we have a summary of all 13 financial ratios for XYZ Corporation. The first thing that jumps out is the low liquidity of the company. We can look at the current and quick ratios for 2022 and 2023 and see that the liquidity is slightly increasing between 2022 and 2023, but it is still very low.

By looking at the quick ratio for both years, we can see that this company has to sell inventory in order to pay off short-term debt. The company does have short-term debt: accounts payable and notes payable, and we don't know when the notes payable will come due.

Let's move on to the asset management ratios. We can see that the firm's credit and collections policies might be a little restrictive by looking at the high receivable turnover and low average collection period. Customers must pay this company rapidly—perhaps too rapidly. There is nothing particularly remarkable about the inventory turnover ratio, but the fixed asset turnover ratio is remarkable.

The fixed asset turnover ratio measures the company's ability to generate sales from its fixed assets or plant and equipment. This ratio is very low for both 2022 and 2023. This means that XYZ has a lot of plant and equipment that is unproductive.

It is not being used efficiently to generate sales for the company. In addition, the company has to service the plant and equipment, pay for breakdowns, and perhaps pay interest on loans to buy it through long-term debt.

It seems that a very low fixed asset turnover ratio might be a major source of problems for XYZ. The company should sell some of this unproductive plant and equipment, keeping only what is absolutely necessary to produce their product.

The low fixed asset turnover ratio is dragging down total asset turnover. If you follow this analysis through, you will see that it is also substantially lowering this firm's return on assets profitability ratio.

With this firm, it is hard to analyze the company's debt management ratios without industry data. We don't know if XYZ is a manufacturing firm or a different type of firm.

As a result, analyzing the debt-to-asset ratio is difficult. What we can see, however, is that the company is financed more with shareholder funds (equity) than it is with debt as the debt-to-asset ratio for both years is under 50% and dropping.

This fact means that the return on equity profitability ratio will be lower than if the firm was financed more with debt than with equity. On the other hand, the risk of bankruptcy will also be lower.

Unfortunately, you can see from the times interest earned ratio that the company does not have enough liquidity to be comfortable servicing its debt. The company's costs are high and liquidity is low. Fortunately, the company's net profit margin is increasing because their sales are increasing.

Hopefully, this is a trend that will continue. Return on Assets is impacted negatively due to the low fixed asset turnover ratio and, to some extent, by the receivables ratios. Return on equity is increasing from 2022 to 2023, which will make investors happy.

As you can see, it is possible to do a cursory financial ratio analysis of a business firm with only 13 financial ratios, even though ratio analysis has inherent limitations.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.2 Operating Efficiency Ratios ." OpenStax.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 2, 4.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 6.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.4 Solvency Ratios ." OpenStax.

Nasdaq. " Fixed-Charge Coverage Ratio ."

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 5.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.6 Profitability Ratios and the DuPont Method ." OpenStax.

What You Need to Know About Calculating Financial Ratios for Your Business Plan

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Understanding how to calculate financial ratios is essential for crafting a robust business plan. These ratios serve as vital indicators of your company’s financial health , guiding strategic decisions and enhancing your potential for growth. In this article, we’ll explore the key ratios you need to include, how to calculate them effectively, and the insights they provide for your business.

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What are financial ratios and why are they important in a business plan?

Definition of financial ratios and their components.

Financial ratios are quantitative measures that provide insights into a company's financial performance and stability. They are derived from the financial data within a business's financial statements, primarily the balance sheet and income statement. Ratios help stakeholders evaluate various aspects of a company's operations, including liquidity, profitability, leverage, and efficiency.

The key components of financial ratios typically include:

• Numerator: The top part of the ratio, which represents a specific financial metric (e.g., net income, total assets).
• Denominator: The bottom part of the ratio, which provides a comparison base (e.g., total liabilities, sales revenue).

Importance of ratios in assessing financial health

Understanding the importance of financial ratios is crucial for any business plan. They serve as vital tools for assessing the financial health of a business, allowing entrepreneurs and investors to make informed decisions. By evaluating financial ratios, stakeholders can identify strengths and weaknesses, gauge operational efficiency, and assess overall financial stability.

Some key reasons why financial ratios are important include:

• They provide a standardized way to compare performance across different periods or against industry benchmarks.
• Ratios help in identifying trends over time, enabling businesses to track their growth or decline.
• They facilitate better communication with investors, lenders, and other stakeholders by providing clear metrics on financial health.

How ratios can guide decision-making and strategic planning

Financial ratios play a crucial role in guiding decision-making and strategic planning within a business. By analyzing key financial ratios, entrepreneurs can uncover insights that inform their strategies and operational adjustments. For instance:

• Liquidity ratios like the current ratio help businesses assess their ability to meet short-term obligations, guiding cash flow management.
• Profitability ratios , such as gross margin and net profit margin, provide insights into pricing strategies and cost management.
• Efficiency ratios , including inventory turnover, indicate how effectively resources are utilized, which can prompt operational improvements.
• Leverage ratios , such as the debt-to-equity ratio, inform decisions regarding financing and risk management.
• Regularly review your financial ratios to stay informed about your business's financial health.
• Benchmark your ratios against industry standards to gain a clearer understanding of your performance.
• Involve your finance team in the calculation and analysis of financial ratios to enhance accuracy and insight.

Which key financial ratios should be included in a business plan?

Overview of liquidity ratios.

Liquidity ratios are essential for assessing a company's ability to meet its short-term obligations. These ratios provide insight into the financial health of a business and its capacity to convert assets into cash quickly. The two primary liquidity ratios to consider are:

• Current Ratio: This ratio compares current assets to current liabilities, indicating whether the business has enough assets to cover its short-term debts. A current ratio above 1 suggests that the company is in a healthy position.
• Quick Ratio: Also known as the acid-test ratio, this measures the ability to meet short-term liabilities without relying on the sale of inventory. It is calculated by subtracting inventory from current assets and then dividing by current liabilities. A quick ratio greater than 1 is generally seen as favorable.

Explanation of profitability ratios

Profitability ratios gauge a company's ability to generate profit relative to its revenue, assets, and equity. These ratios are crucial for investors and stakeholders to understand the business's earning potential. Key profitability ratios include:

• Gross Margin: This ratio represents the percentage of revenue that exceeds the cost of goods sold (COGS). A higher gross margin indicates efficient production and strong pricing strategies.
• Net Profit Margin: This ratio measures how much of each dollar earned translates into profits after all expenses are deducted. A higher net profit margin suggests a more profitable business model.

Discussion on efficiency ratios

Efficiency ratios help assess how well a company utilizes its assets and manages its operations. These ratios are vital for understanding operational performance. Important efficiency ratios include:

• Inventory Turnover: This ratio measures how quickly inventory is sold and replaced over a period. A high inventory turnover ratio indicates effective inventory management and strong sales performance.
• Asset Turnover: This ratio assesses how efficiently a company uses its assets to generate revenue. A higher asset turnover ratio suggests better management of assets in generating sales.

Importance of leverage ratios

Leverage ratios provide insight into the level of debt a business is using to finance its operations and growth. They are crucial for understanding financial risk. The most commonly analyzed leverage ratio is:

• Debt-to-Equity Ratio: This ratio compares a company's total liabilities to its shareholders' equity, indicating the proportion of debt used in financing. A lower debt-to-equity ratio suggests a more stable business with less financial risk, while a higher ratio may indicate potential challenges in managing debt.
• When selecting financial ratios for your business plan, ensure they align with your industry benchmarks to provide context and relevance.
• Regularly update your financial data to maintain accuracy in your ratio calculations, as outdated information can lead to misguided conclusions.

How do you calculate financial ratios effectively?

Step-by-step guide on gathering the necessary financial data.

Calculating financial ratios for your business plan begins with collecting accurate financial data . This data serves as the foundation for all financial analysis and helps ensure that your ratios reflect the true state of your business's financial health. Here are the key steps to gather the necessary information:

• Identify the financial statements required: Typically, you'll need the balance sheet, income statement, and cash flow statement.
• Ensure the data is up-to-date: Use the most recent financial statements to reflect your current financial condition.
• Organize the data: Compile figures relevant to the ratios you plan to calculate, such as total assets, total liabilities, revenue, and net profit.
• Double-check for accuracy: Verify each number against your financial records to avoid errors in your calculations.

Explanation of formulas used for each type of ratio

Once you have gathered your financial data, the next step is to apply the appropriate financial ratio formulas . Here’s a breakdown of some key financial ratios and their calculations:

• Current Ratio: Current Assets / Current Liabilities
• Quick Ratio: (Current Assets - Inventory) / Current Liabilities
• Gross Margin: (Revenue - Cost of Goods Sold) / Revenue
• Net Profit Margin: Net Income / Revenue
• Inventory Turnover: Cost of Goods Sold / Average Inventory
• Asset Turnover: Revenue / Average Total Assets
• Debt-to-Equity Ratio: Total Liabilities / Shareholders' Equity

Tips for ensuring accuracy in calculations

Accuracy in calculating financial ratios is crucial for drawing meaningful insights from your analysis. Here are some tips to enhance the accuracy of your calculations:

• Use consistent accounting methods across all financial statements to ensure comparability.
• Perform calculations multiple times to catch any errors, especially in complex formulas.
• Seek feedback from a financial advisor or accountant to validate your results.
• Document each step of your calculation process for transparency and future reference.

By following these steps to gather financial data, applying the correct formulas, and maintaining accuracy throughout your calculations, you can effectively calculate financial ratios that will provide valuable insights into your business's performance and inform your business strategy moving forward.

What do the financial ratios indicate about your business?

Insights provided by liquidity ratios regarding short-term financial health.

Liquidity ratios are crucial for assessing a company's ability to meet its short-term obligations. These ratios, such as the current ratio and the quick ratio , are indicators of financial stability and operational efficiency. A higher liquidity ratio suggests that a business can cover its current liabilities with its current assets, thus reducing the risk of financial distress.

For example, the current ratio is calculated by dividing current assets by current liabilities. A ratio above 1 typically indicates that the company is in a good position to pay off its debts. Conversely, a quick ratio offers a more stringent measure by excluding inventory from current assets, providing a clearer picture of a company's short-term liquidity.

• Regularly monitor your liquidity ratios to ensure you can respond swiftly to unexpected expenses.

Understanding profitability ratios and their implications for growth

Profitability ratios provide insight into a business's ability to generate profit relative to its revenue, assets, and equity. Key profitability ratios include the gross margin and net profit margin . These ratios not only reveal how efficiently a company is managing its costs but also indicate potential for growth and expansion.

The gross margin ratio, which is calculated by dividing gross profit by total revenue, indicates the percentage of revenue that exceeds the cost of goods sold. A high gross margin signals that a company retains a significant portion of revenue as profit, while the net profit margin reflects the percentage of revenue remaining after all expenses have been deducted. This ratio is crucial for assessing overall profitability and operational efficiency.

• Use profitability ratios to benchmark your performance against competitors and industry standards.

How efficiency ratios can highlight operational effectiveness

Efficiency ratios measure how well a company utilizes its assets and manages its operations. Ratios such as inventory turnover and asset turnover are essential for evaluating operational effectiveness. These ratios provide insights into how effectively a company is using its resources to generate sales.

The inventory turnover ratio indicates how often a company sells and replaces its inventory over a specified period. A higher turnover ratio suggests efficient inventory management and strong demand for products. Similarly, the asset turnover ratio, calculated by dividing total revenue by total assets, assesses how efficiently a company is generating revenue from its assets. A higher ratio indicates effective asset utilization.

• Regularly review your efficiency ratios to identify areas of improvement and optimize operations.

How can financial ratios help in forecasting and budgeting?

Role of historical ratio analysis in predicting future performance.

Analyzing historical financial ratios is an invaluable tool for businesses when it comes to forecasting future performance. By examining past data, companies can identify trends and patterns that may inform their financial outlook. For instance, if a business consistently maintains a strong current ratio , it suggests a stable liquidity position, which can be projected into future periods. Similarly, analyzing profitability ratios like gross margin over time helps in estimating future profitability and operational efficiency.

Techniques for using ratios in budget preparation and resource allocation

Incorporating financial ratios into the budgeting process allows businesses to make more informed decisions regarding resource allocation. Here are some effective techniques:

• Utilize liquidity ratios to ensure that there are enough resources to meet short-term obligations. This aids in creating a budget that maintains operational viability.
• Apply profitability ratios to assess which areas of the business contribute the most to the bottom line, thus guiding strategic investment in those sectors.
• Leverage efficiency ratios to evaluate how effectively resources are being used. For example, a high inventory turnover ratio can indicate that a business should invest more in inventory to meet demand.

Importance of scenario analysis with ratio sensitivity

Scenario analysis is crucial in understanding how changes in key financial ratios can impact a business's financial health. By examining various scenarios—such as changes in sales volume, cost of goods sold, or debt levels—businesses can assess the sensitivity of their financial ratios. This practice helps in preparing for potential risks and opportunities. For example:

• Assessing how a decrease in the debt-to-equity ratio can improve financial stability during economic downturns.
• Evaluating the effects of increased operational costs on profitability ratios , enabling better cost control measures.
• Using historical data to simulate different budget scenarios, allowing businesses to create flexible budgets that adapt to changing conditions.
• Regularly review historical financial ratios to stay informed on trends that may influence future performance.
• Involve multiple stakeholders in the budgeting process to gather diverse perspectives on financial ratio analysis.
• Consider utilizing financial modeling tools to visualize the sensitivity of ratios under varying scenarios.

What are common pitfalls when calculating financial ratios?

Misinterpretation of ratios due to lack of context.

One of the most significant risks when calculating financial ratios is the potential for misinterpretation. Financial ratios, such as the current ratio or debt-to-equity ratio , provide valuable insights, but they must be understood within the broader context of the business and its industry. Ratios can vary widely across sectors, and a seemingly healthy ratio in one industry may indicate distress in another.

For instance, a high gross margin may suggest a profitable business model, but without understanding the competitive landscape or the cost structure, this figure can be misleading. Similarly, liquidity ratios need to be evaluated against the business's operational needs and cash flow cycles to understand their true implications.

Over-reliance on ratios without considering qualitative factors

While financial ratios serve as essential indicators of a company's performance, placing too much emphasis on these numbers can lead to poor decision-making. It is crucial to complement quantitative analysis with qualitative insights. Factors such as management experience, market trends, and customer satisfaction can significantly influence business performance.

For example, a company might have a low inventory turnover ratio, which could imply inefficiency. However, if the business is in a transitional phase—like launching a new product line—this situation may not reflect poor management but rather a strategic pivot that requires time to materialize. Thus, qualitative understanding is vital for a well-rounded analysis.

Importance of benchmarking ratios against industry standards

Benchmarking financial ratios against industry standards is crucial for evaluating a company's performance accurately. Without this perspective, businesses risk drawing erroneous conclusions about their financial health. For instance, a profitability ratio that appears satisfactory in isolation may be underwhelming when compared to industry peers.

Using industry benchmarks allows businesses to identify areas of strength and weakness. It provides context to the numbers and helps stakeholders understand how well the business performs relative to its competition. When developing a business plan, including a comparison of key financial ratios against industry averages can be instrumental in highlighting strategic areas for improvement or investment.

• Always contextualize financial ratios within the industry and operational environment.
• Combine quantitative data with qualitative factors for a more comprehensive analysis.
• Utilize industry benchmarks to evaluate and interpret your financial ratios effectively.

7 How can you present financial ratios in your business plan?

Best practices for visual representation (charts, graphs).

Presenting financial ratios in a visually appealing format can significantly enhance comprehension and engagement. Utilize charts and graphs to illustrate key financial ratios effectively. Here are some best practices:

• Use bar charts for comparing different financial ratios across time periods or against industry benchmarks.
• Employ pie charts to represent the composition of profitability ratios, such as gross margin versus operating expenses.
• Incorporate line graphs to illustrate trends in liquidity ratios, like the current ratio over several quarters.
• Utilize color coding to differentiate between various types of ratios, making it easier for stakeholders to identify critical data points.
• Keep visualizations simple and uncluttered to avoid overwhelming your audience.
• Label all axes and data points clearly to enhance understanding.

How to explain ratios clearly to stakeholders

When presenting financial ratios, clarity is key. Stakeholders may not always have a financial background, so it’s important to explain the ratios in a straightforward manner:

• Begin with a brief definition of each ratio and its significance. For example, explain the current ratio as an indicator of short-term liquidity.
• Provide context by comparing the ratios to industry standards or historical performance to illustrate their relevance.
• Use real-life examples or scenarios to illustrate how these ratios might impact business decisions, such as using the debt-to-equity ratio to assess financial leverage.
• Encourage questions and discussions to ensure stakeholders grasp the implications of the ratios presented.
• Practice your presentation to ensure you can explain complex concepts in simple terms.
• Prepare supplementary materials for stakeholders to reference later, including glossaries or FAQs on financial ratios.

Integrating ratio analysis into overall business strategy narrative

Financial ratios should not exist in isolation; they are integral to your overall business strategy narrative. Here’s how to weave them into your business plan:

• Align ratio analysis with your company’s strategic goals. For instance, if a goal is to improve operational efficiency, highlight your efficiency ratios like inventory turnover.
• Link the financial ratios to actionable insights. Discuss how improving a gross margin can enable reinvestment in growth initiatives.
• Incorporate a forecasting component by projecting how changes in financial ratios can influence future performance, such as predicting how an improved net profit margin could enhance cash flow.
• Regularly revisit and revise your narrative as financial ratios evolve, ensuring that your strategy remains aligned with your financial health assessments.
• Maintain a narrative that reflects both quantitative (ratios) and qualitative (strategic goals) aspects of your business.
• Use case studies or testimonials to bolster your narrative when discussing ratios and their strategic implications.

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4 types of financial ratios to assess your business performance

13-minute read

Keeping track of financial ratios is an essential way for you to examine your company’s financial health.

Ratios reveal basic information about your company, such as whether you have accumulated too much debt, stockpiled too much inventory or are not collecting receivables quickly enough.

Sure, there are the crunch times when you feel you really need them, like an expansion project on the horizon or a customer with a large order asking for longer-than-normal credit terms and you’re not quite sure if you can extend yourself. But checking your ratios should be part of an ongoing assessment of your financials so that you can continuously make informed decisions.

Ratios are included in financial dashboards and management reports; they’re used by bankers or investors when making lending or investment decisions about your business; but, most importantly, they help you understand the health and performance of your company.

“You need objective ways to measure the performance of your business,” says BDC’s Stéphanie Bourret, Senior Manager, Underwriting. “Financial ratios give you that.”

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What are the four types of financial ratios?

Although there are many financial ratios businesses can use to measure their performance, they can be divided into four basic categories.

Liquidity ratios

• Activity ratios (also called efficiency ratios)

Profitability ratios

Leverage ratios, common ratios used to measure financial health.

Liquidity ratio provide a key warning system to a company, letting it know if it's running low on available funds. The ratios measure the amount of liquidity, namely cash and easily converted assets, for covering your debts, and provide a broad overview of your financial health.

These are the ratios to use when you want to know if you can pay your bills.

Examples of liquidity ratios

Current ratio.

The current ratio measures your company’s ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it is calculated by dividing your current assets—such as cash, inventory and receivables—by your current liabilities, such as line-of-credit balance, payables and the current portion of long-term debts .

Current ratio formula

Quick ratio.

The quick ratio , like the current ratio, measures your ability to access cash quickly to support immediate demands. However, the quick ratio excludes inventory. Also known as the acid test ratio, the quick ratio divides the inventory-excluded current assets by current liabilities (excluding the current portion of long-term debts).

Quick ratio formula

How to interpret liquidity ratios.

For both the quick ratio and the current ratio, a ratio of 1.0 or greater is generally acceptable, but this can vary depending on your industry.

A comparatively low current or quick ratio can mean that your company might have difficulty meeting its obligations and may not be able to take advantage of opportunities that require quick cash.

You can improve a low ratio by:

• paying off your liabilities
• delaying purchases
• collecting receivables more quickly

A higher ratio may mean that your capital is being underused and could prompt you to invest more of your capital in projects that drive growth, such as innovation, product or service development, R&D or international marketing.

Liquidity ratios vary by industry

What constitutes a healthy ratio depends on the industry in which your company operates.

A clothing store will have goods that quickly lose value because of changing fashion trends. Still, these goods are easily liquidated and have high turnover, which means the company could function with a current ratio close to 1.0.

An airplane manufacturer has high-value, non-perishable assets such as work-in-progress inventory, as well as extended receivable terms. Businesses like these need carefully planned payment terms with customers; the current ratio should be much higher to allow for coverage of short-term liabilities.

Activity ratios (efficiency ratios)

Activity ratios, also called efficiency ratios are used to measure a company's ability to convert their production into cash or income. Often measure over a three-to-five-year period, they provide insight into areas of your business such as collections, cash flow and operational results.

Examples of activity ratios

Average days inventory.

Average days inventory indicates the average number of days it takes to sell your inventory. You can use this ratio to make sure you don’t over-order or let inventory collect dust from being held for too long.

In general, shorter average days inventory is preferable, as it implies your money is not tied up for long in the process of generating revenue.

Average days inventory formula

1. Calculate average inventory

2. Calculate average days inventory

Average collection period ratio (average days receivable)

Average collection period ratio , also known as average days receivable, looks at the average number of days customers take to pay for your products or services.

The quicker you collect your accounts receivable, the lower your average days receivable, and the sooner you have access to this cash to use in your business. Most companies want to keep the average days receivable between 30 and 45 days, but the standards for this KPI depend on the industry in which you operate.

To improve payment collection, you may want to establish clearer credit policies and set out collection procedures. For example, to encourage your clients to pay on time, you can offer incentives or discounts. You should also compare your policies to those in your industry, to ensure you remain competitive.

Average collection period ratio formula

1. Calculate average accounts receivable

2. Calculate average days receivable

Average days payable ratio

The average days payable ratio measures the average number of days it takes for a company to pay its suppliers.

Your average days payable should not be too high or too low:

• A high ratio indicates that your business is paying suppliers beyond the accepted collection periods, meaning that you are paying interest on your purchases, which in turn could affect your business’s credit rating. An increasing ratio can indicate that a company is having difficulty paying its bills.
• A low ratio indicates that your business is not taking advantage of your suppliers’ payment terms and that you are unable to take full advantage of their purchase credit.

Average days payable ratio formula

1. Calculate average accounts payable

2. Calculate average days payable

Cash conversion cycle

The cash conversion cycle measures how fast your company can convert its cash on hand into inventory, and then convert inventory back into cash.

Figuring out how long this cycle takes allows you to understand how many days your company’s cash will be tied up.

A positive cash conversion cycle means that your daily operations are tying up cash. You may need extra financing to support the business and pay your suppliers on time.

A negative cash conversion cycle means your day-to-day operations are moving cash quickly through the business and you will not have any problem paying supplier invoices.

Cash conversion cycle formula

Average days inventory + Average days receivable - Average days payable

Inventory turnover ratio

The inventory turnover ratio tells you how fast your goods are selling. It allows you to see how long it takes for inventory to be sold and replaced during the year. For most inventory-reliant companies, this can be a make-or-break factor for success. After all, the longer the inventory sits on your shelves, the more costly it becomes.

Assessing your inventory turnover is important because gross profit is earned each time such turnover occurs. Inventory turnover ratio will help you identify areas for improving your buying practices and inventory management . For example, you could analyze your purchasing patterns to determine ways to minimize the amount of inventory on hand. You might want to turn some of the obsolete inventory into cash by selling it off at a discount to specific clients.

Inventory turnover formula

Inventory turnover ratio is calculated by dividing total purchases by average inventory in a given period.

Profitability ratios are used to evaluate how much money your business is making or losing.

These are the ratos to use when you want to know how much profit you're earning.

Examples of profitability ratios

Gross profit margin.

Gross profit margin is the amount of money a company has left after paying all the direct costs of producing or purchasing the goods or services it sells.

The higher the gross profit margin, the more money the company can afford for its indirect costs and other expenses like interest.

The gross profit margin is expressed in dollars while the gross profit margin ratio is shown as a percentage of revenue. Both are often referred to as gross margin.

These ratios are used not only to evaluate the financial viability of your business but are essential in comparing your business to others in your industry. You can also look for trends in your company by comparing the ratios over a number of years. Business owners and finance professionals use them as a measure of a company’s operational performance over time and to compare and rank groups of companies based on their performance.

Gross profit margin formula

The gross profit margin is calculated by subtracting direct expenses or cost of goods sold (COGS) from net revenue (gross revenues minus returns, allowances and discounts). That number is divided by net revenues, then multiplied by 100% to calculate the gross profit margin ratio.

Net profit margin

Net profit margin reveals the amount of profit you’re taking in. It measures how much a company earns (usually after taxes) relative to its sales. A company with a higher net profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities.

The standards for this KPI depend on the industry in which your company operates.

Net profit margin formula

Return on assets ratio.

Return on total assets ratio calculates how well the company’s various resources (assets) are being used. The results of this ratio are often used to compare a business to its competitors.

It should also be noted that average ratios will vary widely across different industries.

• Capital-intensive industries such as railways will yield a low return on assets, since they need expensive infrastructure to do business.
• Service-based operations such as consulting firms will have a high ROA, as they require few hard assets to operate.

Return on assets formula

Return on equity.

Return on equity (ROE) measures how well the business is doing in relation to the investments made.

Like the return on total assets ratio, it is often used by business owners to compare how much the company is earning for each dollar invested in the company. It can also be useful for a business to examine the development of its own return on equity ratio over time.

Return on equity formula

Return on equity is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity and then multiplying the result by 100%.

Cross-sectional analysis

A common analysis tool for profitability ratios is cross-sectional analysis, which compares ratios of several companies from the same industry.

For instance, your business may have experienced a downturn in its net profit margin of 10% over the last three years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is performing relatively well.

Nonetheless, you will still need to analyze the underlying data to establish the cause of the downturn and create solutions for improvement.

Leverage ratios measure the overall debt level of a business, as well as a business’s ability to repay new and existing loans.

These are ratios to use when you want to know how extensively you’re using debt to support your business.

Examples of leverage ratios

Debt-to-equity ratio.

The debt-to-equity ratio measures how much you are using debt to finance your business relative to equity.

High ratios indicate the company relies heavily on debt. While lower ratios point to a healthier reliance on debt, although it can sometimes point to an overly prudent approach to investing.

Debt-to-equity ratio is used by bankers to see how your assets are financed, whether it comes from creditors or your own investments, for example. In general, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities.

Debt-to-equity ratio formula

Debt-to-asset ratio.

Debt-to-asset ratio is similar to debt-to-equity ratio. It determines a company’s level of indebtedness, in other words, the proportion of its assets that is owned by its creditors.

This ratio shows that most of the assets are financed by debt when the ratio is greater than 1.0.

Debt-to-asset ratio formula

Debt service coverage ratio.

The debt service coverage ratio (also known as the debt servicing ratio) measures how much EBITDA (earnings before interest, taxes, depreciation and amortization) a company generates for every dollar of interest and principal paid.

Higher ratios are preferable because they indicate your company can easily service its debt.

The debt service coverage ratio is widely used by bankers and investors to understand the level of indebtedness of a company and its prospects moving forward.

Debt service coverage ratio formula

Accessing and calculating ratios.

To determine your ratios, you can use a variety of online tools such as BDC’s financial tools or ask your financial advisor, accountant or banker for the most currently used ratios.

How are financial ratios used in decision making?

Lenders looking at your balance sheet will use financial ratios to determine the stability and health of your business.

They may also make financial ratios a part of your business loan agreement. For instance, they may require that you keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities. This type of request is called a covenant .

But ratios should not be evaluated only when visiting your banker. Ideally, you should review your ratios on a monthly basis to keep on top of the fluctuations every company experiences.

Which ratios are relevant to your business?

Every ratio gives you a different insight into your business; how you use them depends on your particular goals.

If you’re looking to grow and need to raise capital, for example, your net profit margin will be key. “The more profit you can show, the better your chances are of raising the cash you need,” says Bourret.

On the other hand, if you’ve launched a new product, you’ll want to track your inventory turnover to make sure you’re aligned with demand. “You want to see that the inventory you keep isn’t old news, that people want to buy the product.”

You always want to be adapting and innovating, and ratios can help you do that.

Stéphanie Bourret

Senior Manager, Underwriting, BDC

Some ratios are important to specific industries:

• Occupancy ratio in the hotel sector
• Capital adequacy ratio in banking
• Sales per square foot in retail
• Customer lifetime value to customer acquisition cost ratio in the tech sector

Know which ratios give the information most relevant to your sector.

How to use financial ratios

Once you’ve determined which ratios to use, compare the results over time to pick out trends or changes in your business performance.

For example, if your net profit margin climbed regularly for three years and then took a dip, what changed?

• Were your revenues down in one particular quarter?
• Have your costs gone up?
• Do you need to take any actions?

Use ratios to drive strategy

The insights that come from the ratios you use should shape the direction of your business plan . “Status quo can kill the potential of a business,” says Bourret. “You always want to be adapting and innovating, and ratios can help you do that.”

For example, if you’re not turning over your receivables fast enough, you may have a cash flow problem. You can address that by changing your procedures or company culture to collect payments more proactively. Or if you see your inventory is turning over too slowly, maybe you need to look at your product mix and either add something new or get rid of something old.

Bourret says ratios are a major part of your profit-making arsenal. “Use them right and you end up with more money in your pocket.” If you’re not sure which ones are right for your business, or how to use them, get advice from your accountant or a BDC business advisor . An expert can help you zero in on where you need to focus your efforts.

Where can I find industry financial ratios?

Ratios also help you see how your business compares to others in your industry.

While every industry is different, knowing the industry average gives you a general sense of where you want to be. Average ratios are also available for complete sectors and companies of comparable size.

Industry-standard data is available for a fee from a variety of sources. Industry Canada’s Financial Performance Data , offers basic financial ratios by industry, all based on Statistics Canada data.

Discover how to use financial ratios to track and analyze your company’s development by downloading the free BDC guide, Monitoring Your Business Performance .

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What is Ratio Analysis?

Uses of ratio analysis.

• Ratio Analysis - Categories of Financial Ratios

Related Readings

Ratio analysis.

Comparisons between the financial information in the financial statements of a business

Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business. They are mainly used by external analysts to determine various aspects of a business, such as its profitability, liquidity, and solvency.

Analysts rely on current and past financial statements to obtain data to evaluate the financial performance of a company. They use the data to determine if a company’s financial health is on an upward or downward trend and to draw comparisons to other competing firms.

1. Comparisons

One of the uses of ratio analysis is to compare a company’s financial performance to similar firms in the industry to understand the company’s position in the market. Obtaining financial ratios, such as Price/Earnings, from known competitors and comparing them to the company’s ratios can help management identify market gaps and examine its competitive advantages , strengths, and weaknesses. The management can then use the information to formulate decisions that aim to improve the company’s position in the market.

2. Trend line

Companies can also use ratios to see if there is a trend in financial performance. Established companies collect data from financial statements over a large number of reporting periods. The trend obtained can be used to predict the direction of future financial performance , and also identify any expected financial turbulence that would not be possible to predict using ratios for a single reporting period.

3. Operational efficiency

The management of a company can also use financial ratio analysis to determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets such as motor vehicles, land, and buildings results in unnecessary expenses that ought to be eliminated. Financial ratios can also help to determine if the financial resources are over- or under-utilized.

Ratio Analysis – Categories of Financial Ratios

There are numerous financial ratios that are used for ratio analysis, and they are grouped into the following categories:

1. Liquidity ratios

Liquidity ratios measure a company’s ability to meet its debt obligations using its current assets. When a company is experiencing financial difficulties and is unable to pay its debts, it can convert its assets into cash and use the money to settle any pending debts with more ease.

Some common liquidity ratios include the quick ratio , the cash ratio, and the current ratio. Liquidity ratios are used by banks, creditors, and suppliers to determine if a client has the ability to honor their financial obligations as they come due.

2. Solvency ratios

Solvency ratios measure a company’s long-term financial viability. These ratios compare the debt levels of a company to its assets, equity, or annual earnings.

Important solvency ratios include the debt to capital ratio, debt ratio, interest coverage ratio, and equity multiplier. Solvency ratios are mainly used by governments, banks, employees, and institutional investors.

3. Profitability Ratios

Profitability ratios measure a business’ ability to earn profits, relative to their associated expenses. Recording a higher profitability ratio than in the previous financial reporting period shows that the business is improving financially. A profitability ratio can also be compared to a similar firm’s ratio to determine how profitable the business is relative to its competitors.

Some examples of important profitability ratios include the return on equity ratio, return on assets, profit margin, gross margin, and return on capital employed .

4. Efficiency ratios

Efficiency ratios measure how well the business is using its assets and liabilities to generate sales and earn profits. They calculate the use of inventory, machinery utilization, turnover of liabilities, as well as the usage of equity. These ratios are important because, when there is an improvement in the efficiency ratios, the business stands to generate more revenues and profits.

Some of the important efficiency ratios include the asset turnover ratio , inventory turnover, payables turnover, working capital turnover, fixed asset turnover,  and receivables turnover ratio.

5. Coverage ratios

Coverage ratios measure a business’s ability to service its debts and other obligations. Analysts can use the coverage ratios across several reporting periods to draw a trend that predicts the company’s financial position in the future. A higher coverage ratio means that a business can service its debts and associated obligations with greater ease.

Key coverage ratios include the debt coverage ratio, interest coverage, fixed charge coverage, and EBIDTA coverage.

6. Market prospect ratios

Market prospect ratios help investors to predict how much they will earn from specific investments. The earnings can be in the form of higher stock value or future dividends. Investors can use current earnings and dividends to help determine the probable future stock price and the dividends they may expect to earn.

Key market prospect ratios include dividend yield, earnings per share, the price-to-earnings ratio , and the dividend payout ratio.

Thank you for reading CFI’s guide to Ratio Analysis. To keep learning and advancing your career, the following CFI resources will be helpful:

• Analysis of Financial Statements
• Current Ratio Formula
• Financial Analysis Ratios Glossary
• Limitations of Ratio Analysis
• See all accounting resources
• See all capital markets resources
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Essential Financial Ratios for Business Owners: Formulas & Best Practices

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Decode your company's financial health by analyzing these ratios from your financial statements.

How do you know if your business is in step with its competitors? Or, that you’re in a good position to seek financing? For growing companies hoping to sustain profit margins, expand or improve everyday operations, incorporating routine financial ratio analysis is an important practice at any stage or size. By evaluating key financial ratios such as the current ratio, gross profit margin or debt-to-equity ratio, for example, business owners can benchmark against industry standards, assess strengths and weaknesses and make strategic decisions for the future.

Financial Ratios Paint a Bigger Picture of Your Business 

Your numbers, at face value, can provide a lot of information. However, understanding the relationship between certain numbers or variables—e.g., equity versus debt or assets versus liabilities—gives you a better snapshot of your operational efficiency, liquidity, solvency and profitability. 

That’s where financial ratios come into play.

Financial ratios are numerical comparisons derived from your financial statements—the balance sheet , income statement and cash flow statement . These ratios encapsulate information into digestible metrics that can be measured and tracked over time. They also enable your stakeholders, such as investors, lenders or leadership, to make informed decisions and benchmark against industry standards.

How Often Should You Calculate & Analyze Financial Ratios?

There are many different kinds of financial ratios, from profitability ratios to valuation ratios, all of which can be useful at different intervals. 

When measuring operational efficiency or profitability, for example, quarterly ratio calculations and analysis are helpful to understand if performance is declining, improving or staying the same. These are easily calculated by your accountant or finance team when creating your financial statements. However, you may want to analyze more specialized ratios for specific events, such as financing. 

Consider taking a closer look at your financial ratios when…

• Applying for financing from a bank or lender . Lenders use ratios like debt-to-equity to assess your creditworthiness.  
• Starting your budgeting cycle . Ratios help you set benchmarks for financial goals and highlight your areas of strength or vulnerability. 
• Evaluating major business decisions . Your financial ratios can help you determine if a future transaction or major investment is even possible for your business.
• Monitoring performance against your industry . Compare profitability and efficiency ratios against your competitors to detect risks or major disadvantages. 
• Reporting or adhering to regulations . Whether you’re reporting for investors or for compliance purposes, you may be required to consistently provide specific ratios. 
• Fixing cash flow issues . Ratios can help you diagnose the issue behind your cash flow crunch. 

Your Financial Ratios Cheat Sheet: 11 Ratios for Business Owners

There are hundreds of ratios that businesses have at their disposal, but it’s easiest to start with the most common ratios and get more specific based on your business model, industry and strategic objectives. 

These financial ratios incorporate liquidity, solvency, profitability and efficiency both for private and public companies. While your business may not use all of these ratios, they’re helpful to know for a better overall business understanding. 

1. Current Ratio

The current ratio is a liquidity ratio that measures your company’s ability to meet its short-term obligations with its short-term assets. A higher current ratio indicates a stronger liquidity position, essential for sustaining operations and seizing growth opportunities.

Calculation: Current Ratio = Current Assets / Current Liabilities

Note: If you want to dig deeper into liquidity, you can also assess your cash conversion cycle. While this is not a ratio, it does measure how quickly your business converts investments, such as inventory, into cash. You can calculate this by adding the days your inventory sits without being sold to the days it takes to collect receivables. Then, subtract how long you defer payments to your suppliers. 

2. Debt-to-Equity Ratio

This solvency ratio assesses your financial leverage by comparing your company’s total liabilities to your shareholders’ equity. It provides insights into how you’re financing operations and growth and how much reliance you put on equity versus debt financing. A lower debt-to-equity ratio is generally preferred, because it signals less risk.

Calculation: Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

3. Gross Profit Margin

The gross profit margin is a profitability ratio that reveals the percentage of revenue that exceeds the cost of goods sold (COGS). It underscores the efficiency of production processes and pricing strategies. A higher margin indicates better profitability and cost management.

Calculation: Gross Profit Margin = (Revenue – COGS) / Revenue * 100

4. Return on Equity (RoE)

For public companies, RoE is a measure of profitability in relation to shareholders’ equity. It indicates how effectively management is using equity to generate profit, so businesses should strive for a higher percentage. 

Calculation: Return on Equity = Net Income / Shareholders’ Equity * 100

5. Inventory Turnover Ratio

This efficiency ratio measures how quickly your company sells and replaces its inventory within a given period. A higher turnover indicates efficient inventory management and sales performance, reducing holding costs and freeing up capital.

Calculation: Inventory Turnover Ratio = COGS / Average Inventory

6. Net Profit Margin

The net profit margin is a critical profitability ratio that indicates the percentage of revenue that remains as net income after all expenses, taxes and interest payments are deducted. It provides a comprehensive view of overall profitability and operational efficiency.

Calculation: Net Profit Margin = Net Income / Revenue * 100

7. Return on Assets (RoA)

RoA measures how efficiently your company’s assets are being used to generate profit. It reflects the ability of management to convert investments in assets into earnings, offering insights into the productivity and asset utilization of the business.

Calculation: Return on Assets = Net Income / Total Assets * 100

8. Quick Ratio (Acid-Test Ratio)

The quick ratio is a more stringent liquidity ratio than the current ratio, as it excludes inventory from current assets. It assesses the capacity to meet short-term obligations with the most liquid assets, providing a clearer picture of immediate liquidity without relying on inventory liquidation.

Calculation: Quick Ratio = (Current Assets – Inventory) / Current Liabilities

9. Asset Turnover Ratio

This efficiency ratio evaluates how effectively your company uses its assets to generate sales. In other words, it signals how well management leverages investment in things like production facilities, equipment, intellectual property and other assets to generate revenue. A higher asset turnover ratio suggests that the company is using its assets efficiently to increase sales, indicative of operational effectiveness.

Calculation: Asset Turnover Ratio = Revenue / Average Total Assets

10. Customer Acquisition Cost (CAC) Ratio

The CAC ratio is a marketing ratio that calculates how much a company spends to acquire each new customer. It offers visibility into the efficiency of sales and marketing investments against revenue growth. A lower ratio is typically preferred.

Calculation: CAC = Sales & Marketing Expenses / Number of New Customers

Note: You can also compare CAC to lifetime customer value (LTV) to see how the price of acquiring customers compares to customer value across the lifecycle. 

11. Price-to-Earnings Ratio (P/E Ratio)

For public companies, the P/E ratio is a vital market valuation ratio that compares a company’s share price to its earnings per share (EPS). It provides investors with insights into market expectations and the company’s growth prospects. A higher P/E ratio may indicate that the market expects future growth in earnings.

Calculation: Price-to-Earnings Ratio = Market Price per Share / Earnings per Share (EPS)

Implementing Financial Ratio Analysis in Your Business

To harness the full potential of financial ratios, business owners should integrate them into regular financial reviews and strategic planning sessions. Here’s a streamlined approach to applying financial ratio analysis effectively:

• Consistently track financial ratios over time (at least quarterly) to monitor financial performance trends.
• Compare financial ratios against published industry benchmarks to gauge business standing relative to standards.
• Establish internal ratio-based targets aligned to financial objectives and strategic priorities.
• Analyze trends between different ratios to identify deeper issues impacting performance.
• Make financial ratios central in company-wide metrics and KPIs across departments.
• Relate staff responsibilities like inventory management to broader ratio metrics.
• Use ratios as proactive measures, not just compliance reporting.
• Engage fractional financial advisors or accountants to delve deeper into ratio analysis, interpret complex findings and improve strategy.

Get Support In Analyzing Your Numbers

Entrepreneurs can transform raw numbers into action through robust ratio analysis. However, your key financial ratios may be slightly different or more complex. In order to set the right targets for your business, it’s best to consult with an expert. Paro’s on-demand accounting and finance experts are available to help you decode your financial statements and assess your company’s standing against the competition. Match with a highly-vetted expert in just hours. 

Glossary of Terms: 

• Current assets : Cash and assets that can be converted to cash within a year (e.g., cash, accounts receivable, inventory)
• Shareholders’ equity : The corporation’s total assets minus its total liabilities, also called stockholders’ equity or owners’ equity
• Cost of goods sold (COGS) : Direct production costs of goods produced by the company, such as raw materials, direct labor, operational overhead
• Net income : The income left after subtracting all expenses from revenues over an accounting, also considered the bottomline period
• Total assets : Everything the business owns that holds economic value, including current assets and long-term assets like property, plant & equipment
• Earnings per share (EPS) : The company’s net profit allocated to each outstanding share of common stock, demonstrating profitability on a per-share basis

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Home > Blog > 5 key Financial Ratios and How to use them

5 key Financial Ratios and How to use them

by Datarails

What are financial ratios?

Financial ratios are basic calculations using quantitative data from a company’s financial statements . They are used to get insights and important information on the company’s performance, profitability , and financial health.

Common financial ratios come from a company’s balance sheet, income statement, and cash flow statement.

Businesses use financial ratios to determine liquidity, debt concentration, growth, profitability, and market value.

Why are financial ratios so important?

Financial ratios are sometimes referred to as accounting ratios or finance ratios. These ratios are important for assessing how a company generates revenue and profits using business expenses and assets in a given period. Internal and external stakeholders use financial ratios for competitor analysis, market valuation, benchmarking, and performance management.

Financial Ratios inside a business

Financial planning and analysis professionals calculate financial ratios for the following reasons for internal reasons.

● To measure return on capital investments

● To calculate profit margins

● To assess a company’s efficiency and how costs are allocated

● To determine how much debt is used to finance operations

● To identify trends in profitability

● To manage working capital and short-term funding requirements

● To identify operating bottlenecks and assess inventory management systems

● To measure a company’s ability to settle debt and liabilities

How analysts and external stakeholders use Financial Ratios

External stakeholders use financial ratios to:

● Carry out competitor analysis

● Determine whether to finance a company in the form of debt

● Assess how profitable a company is

● Determine whether to provide equity financing or buy shares in the company

● Calculate tax liabilities

● Measure a company’s market value

● Calculate return on shareholders’ equity

● Perform market analysis

Financial Ratios Excel Template

Below is an Excel template with all of the formulas needed for calculating each of the 5 financial ratios. Plug in your company’s numbers and get a quick and accurate picture of where you stand on liquidity, debt concentration, growth, profitability, and market value.

5 Essential Financial Ratios for Every Business 

The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.

1)   Liquidity ratios

Companies use liquidity ratios to measure working capital performance – the money available to meet your current, short-term obligations .

Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a company’s capacity to meet its short-term obligations and are a vital indicator of its financial health. Liquidity is different from solvency, which measures a company’s ability to pay all its debts. In the sporting world, Italian football club Lazio faces a now-infamous liquidity ratio preventing it from signing new players. Italian clubs are required to communicate their liquidity indicator to the football authorities twice a year. This indicator cannot be any lower than a certain threshold set by the football authorities.

There are different forms of liquidity ratio.

  Current ratio: Current Assets / Current Liabilities

The current ratio measures how a business’s current assets, such as cash, cash equivalents, accounts receivable, and inventories, are used to settle current liabilities such as accounts payable.

Quick ratio (Acid-test ratio): (Current Assets – Inventories – Prepaid Expenses) / Current Liabilities

Also known as the acid-test ratio, the quick ratio measures how a business’s more liquid assets, such as cash, cash equivalents, and accounts receivable can cover current liabilities. This ratio excludes inventories from current assets. A quick ratio of 1 is considered the industry average. A quick ratio below 1 shows that a company may not be in a position to meet its current obligations because it has insufficient assets to be liquidated. (Acid test refers to a quick and simple test gold miners used to determine whether samples of metal were true gold or not. Acid would be added to a sample; if it dissolved, it wasn’t gold. If it stood up to the acid, it likely was). From a great real example on the Street.com see how Apple’s Quick Ratio stacks up:

Quick Ratio Example: Apple (NASDAQ: AAPL)

The following figures are as of March 27th, 2021, and come from Apple’s balance sheet. Numbers are in millions of dollars.

Cash and cash equivalents: $38,466

Accounts receivable: $18,503

Marketable securities: $31,368

Current liabilities: $106,385

QR = Liquid Assets / Current Liabilities

QR = ($38,466 + $18,503 +$31,368) / $106,385

QR = $88,337 / $106,385

Based on this calculation, Apple’s quick ratio was 0.83 as of the end of March 2021. This number could be higher if more assets were included in its calculations.

Cash ratio: Cash and cash equivalents / Current Liabilities

The cash ratio measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities. This ratio shows how quickly a company can settle current obligations.

2)    Leverage ratios

Companies often use short and long-term debt to finance business operations. Leverage ratios measure how much debt a company has. Molson Coors Beverage Co. , the maker of Coors Light and Miller Lite beer for instance, had been saddled with debt, after an acquisition in the industry according to the Wall Street Journal . Its CFO Tracey Joubert signaled to the market the company’s plans “reduce its leverage ratio to below 3 times by the end of this year.” The types of leverage ratio to consider are:

Debt ratio: Total Debt / Total Assets

The debt ratio measures the proportion of debt a company has to its total assets. A high debt ratio indicates that a company is highly leveraged.

Debt to equity ratio: Total Debt / Total Equity

The debt-to-equity ratio measures a company’s debt liability compared to shareholders’ equity. This ratio is important for investors because debt obligations often have a higher priority if a company goes bankrupt.

Interest coverage ratio: EBIT / Interest expenses

Companies generally pay interest on corporate debt. The interest coverage ratio shows if a company’s revenue after operating expenses can cover interest liabilities.

3)   Efficiency ratios

Efficiency ratios show how effectively a company uses working capital to generate sales. For instance an analyst reported that Seattle-based bank Washington Federal’s company’s efficiency ratio was 58.65%, down from 59.02% recorded a year ago. A fall in efficiency ratio indicates improved profitability. There are several ways to analyze efficiency ratios:

Asset turnover ratio: Net sales / Average total assets

Companies use assets to generate sales. The asset turnover ratio measures how much net sales are made from average assets.

Inventory turnover: Cost of goods sold / Average value of inventory

For companies in the manufacturing and production industries with high inventory levels, inventory turnover is an important ratio that measures how often inventory is used and replaced for operations.

Days sales in inventory ratio: Value of Inventory / Cost of goods sold x (no. of days in the period)

Holding inventory for too long may not be efficient. The day sales in inventory ratio calculates how long a business holds inventories before they are converted to finished products or sold to customers.

Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average Accounts Payable

The payables turnover ratio calculates how quickly a business pays its suppliers and creditors.

Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period (or year)

This ratio shows how many days it takes a company to pay off suppliers and vendors. A lower days payables outstanding implies that a business is letting go of cash too quickly and may not be taking advantage of longer credit terms. On the other hand, when the DPO is too high, it means a company delays paying its suppliers, which can lead to disputes.

Receivables turnover ratio: Net credit sales / Average accounts receivable

Accounts receivables are credit sales made to customers. It is important that companies can readily convert account receivables to cash. Slow paying customers reduce a business’s ability to generate cash from their accounts receivable.

The receivables turnover ratio helps companies measure how quickly they turn customers’ invoices into cash. A high receivables turnover ratio shows that a company quickly generates cash from accounts receivables.

4)    Profitability ratios

A business’s profit is calculated as net sales less expenses. Profitability ratios measure how a company generates profits using available resources over a given period. Higher ratio results are often more favorable, but these ratios provide much more information when compared to results of similar companies, the company’s own historical performance, or the industry average. Some of the most common profitability ratios are:

Gross margin: Gross profit / Net sales

The gross margin ratio measures how much profit a business makes after the cost of goods and services compared to net sales. Comparing companies can be illustrative – such as finding that Home Depot has a 33.6% gross profit margin versus Walmart’s 25.1%.

Operating margin: Operating income / Net sales

The operating margin measures how much profit a company generates from net sales after accounting for the cost of goods sold and operating expenses.

Return on assets (ROA): Net income / Total assets

Companies use the return on assets ratio to determine how much profits they generate from total assets or resources, including current and noncurrent assets.

Return on equity (ROE): Net income / Total equity

Shareholders’ equity is capital investments. The return on equity measures how much profit a business generates from shareholders’ 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 ROI .

5)   Market Value ratios

Market value ratios are used to measure how valuable a company is. These ratios are usually used by external stakeholders such as investors or market analysts but can also be used by internal management to monitor value per company share.

Earnings per share ratio (EPS) : (Net Income – Preferred Dividends) / End-of-Period Common Shares Outstanding

The earnings per share ratio, also known as EPS, shows how much profit is attributable to each company share.

Price earnings ratio (P/E): Share price / Earnings per share

The PE ratio is a key investor ratio that measures how valuable a company is relative to its book value earnings per share.

Book value per share ratio: (Total Equity – Preferred Equity) / Total shares outstanding

A company’s common equity is what common shareholders own after all liabilities and preference shares have been settled from total assets.

The book value per share measures the value per share for common equity owners based on the balance sheet value of assets less liabilities and preference shares.

Dividend yield ratio: Dividend per share / Share price

The dividend yield ratio measures the value of a company’s dividend per share compared to the market share price.

When companies pay out dividends to shareholders, the value of dividends received for each share owned is known as the dividend per share. Shareholders and analysts compare the dividend per share to the company’s share price using the dividend yield ratio.

Best Practices For Using Financial Ratios

Financial ratios help senior management and external stakeholders measure a company’s performance. These best practices will drive effective decision-making.

● Compute financial ratios with accurate financial numbers

● Compare ratios across periods to identify performance trends

● Use relative competitor and industry benchmarks to measure performance

● Calculate ratios using balance sheet averages where applicable

● Interpret financial ratios correctly to support key business decisions

● Calculate and analyze ratios using the balance sheet , income statement , and cash flow statement to get a holistic view of the business’s performance

Final Thoughts

Financial ratios are good key performance indicators used to measure a company’s performance over time compared to competitors and the industry. Calculating accurate financial ratios and interpreting the ratios help business leaders and investors make the right decisions. 

The Datarails team is made up of finance professionals, FP&A analysts, and business leaders from a variety of industries.

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Ratio Analysis: Why it’s Important for Your Small Business

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Our Small Business Expert

Ratio analysis is the act of using various components of financial information in order to provide a snapshot of a company’s financial health. Ratio analysis is frequently used by business owners as well as investors who want better insight into the financial performance of the business in a variety of areas.

Overview: What is ratio analysis?

Ratio analysis can be used in numerous ways, but is most often used to view and analyze trends, compare results with similar businesses, and offer investors insight into the financial well-being of a company they may be interested in.

There are hundreds of variations of financial ratios that can be performed, with many of the calculations requiring only accurate financial statements in order to complete.

However, understanding the results of the calculations is more challenging for small business owners with limited knowledge of bookkeeping or accounting processes.

Ratio analysis categories

Though there are hundreds of different accounting ratios that a business can use to analyze business health and performance, there are five basic categories of ratios that businesses most frequently use. We’ve included the five most common ratio categories as well as an example of a ratio in each particular category.

1. Profitability ratio

Of all the ratios, profitability ratios are probably used most frequently. Profitability ratios measure exactly how effectively a company uses its assets and controls expenses. The gross profit ratio is a good example of a profitability ratio, and is an easy formula:

Total sales – Cost of goods sold = Gross profit ratio

The numbers needed to perform the gross profit ratio are found on your income statement. For instance, a gross profit ratio of 55% means that for every dollar of sales, $0.55 in profit is earned.

A low gross profit ratio means that you’re not generating enough revenue from sales. Profitability ratios, such as cost accounting ratios, can be particularly useful for manufacturing companies.

2. Activity ratio

Activity ratios are designed to measure how effective assets such as inventory or accounts receivable are used. The inventory turnover ratio is a good example of an activity ratio. The inventory turnover ratio involves multiple steps:

• Determine the cost of goods sold, which is found on your income statement.
• Find your beginning and ending inventory totals for the period you wish to calculate turnover ratio for. For instance, if you’re looking for average inventory for the month, you would run a balance sheet on the first day of the month, and the last day of the month, and add the inventory totals from each balance sheet.

Beginning inventory ÷ Ending inventory = Average inventory

• Calculate the turnover ratio:

Cost of goods sold ÷ Average inventory = Inventory turnover ratio

An inventory ratio of 2 means that stock was replenished twice in the specified period of time. An inventory turnover ratio between 2 and 4 indicates that inventory is selling at a profitable rate, while a ratio of less than 1 means that you’re likely overstocked.

3. Liquidity ratio

Liquidity ratios are used to measure the amount of cash available to pay debt. A quick ratio, otherwise known as the acid ratio, is a perfect example of a liquidity ratio. The quick ratio is a simple calculation, using current assets and current liabilities found on your balance sheet.

Current assets ÷ Current liabilities = Quick ratio

A quick ratio of 1 is considered normal, meaning that assets and liabilities are equal. A ratio higher than 1 indicates that your business has more assets than liabilities, while a ratio of less than 1 indicates that your current assets are not sufficient to pay your current liabilities.

4. Debt or leverage ratios

Debt or leverage ratios are completed in order to determine if a company is in position to repay their long-term debt. The most common debt or leverage ratio is the debt-to-equity ratio. The formula for calculating debt to equity is simple:

Total liabilities ÷ Total equity = Debt-to-equity ratio

A debt-to-equity ratio of 1 means that investors and creditors own assets equally, while a ratio higher than 1 means that creditors own more assets than investors, which can indicate that the business is a risky investment.

5. Market ratios

Market ratios measure stock cost and current investment value. The dividend payout ratio is a ratio that compares investor payout to net income generated by a company, and shows current and potential investors how much of their net income a company is distributing to shareholders.

There are several formulas for calculating the dividend payout ratio, with the easiest formula as follows:

Total dividends ÷ Net income = Dividend payout ratio

For example, a dividend payout ratio of 0.20 or 20% means that 20% of net income is distributed to shareholders, while 80% of net income is kept by the company in the form of retained earnings.

How to use ratio analysis

Before calculating ratios, it may be helpful to revisit some frequently used accounting terms that can make the analysis process much simpler.

While investment professionals tend to use financial ratio analysis on a regular basis, it can also be beneficial for small business owners as well.

Business owners will find that using financial ratio analysis can help analyze performance trends while also helping spot potential problems. While some ratios are too complex for smaller businesses, there are numerous ratios that smaller businesses can easily calculate.

Using the example balance sheet below, we’ll calculate a few ratios.

Example balance sheet for ABC Manufacturing

ABC Manufacturing wants to calculate a current ratio. The formula for a current ratio is

Current assets ÷ Current liabilities = Current ratio

Using the balance sheet totals, here is the calculation for a current ratio:

$253,000 ÷ $70,000 = 3.61

This means that ABC Manufacturing has more than three times as many current assets as current liabilities. Anything greater than 1 is considered good, though if the current ratio is too high, it can indicate that current assets are not being used properly.

A current ratio less than 1 can indicate that your business may have trouble meeting current financial obligations.

Now, we’ll calculate a debt-to-asset ratio, which tells you how much debt your business has assumed and whether you’ve taken on too much debt.

The debt to asset ratio formula is

Total liabilities ÷ Total assets = Debt-to-asset ratio

Using the balance sheet totals, we’ll calculate the debt to asset ratio:

$235,000 ÷ $473,000 = 0.49

This means that your debt to asset ratio is 0.49%, or that you have nearly twice as much in assets as liabilities. Anything less than 0.50 is considered good, while greater 1 is considered high-risk.

Ratio analysis is worth the effort

Calculating ratios for financial analysis is an important part of running a successful business. Even small business owners can benefit from calculating financial ratios, such as accounts receivable turnover, a quick ratio, or a debt-to-asset ratio.

If you’re an accounting novice or unsure which ratios may be beneficial for your business, check with an experienced accountant or CPA for suggestions.

The key to using ratio analysis is keeping accurate financial statements. Using numbers found on a financial statement, ratios can pinpoint what your business is doing right, where it’s headed, and where it may be running into problems.

If you’re looking for accounting software that offers solid financial reporting options, be sure to check out The Ascent’s accounting software reviews .

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Financial Ratios Analysis and Its Importance

Dive into financial mastery with our comprehensive guide to financial ratios analysis and its importance in sculpting business success. This blog unravels the tapestry of numbers and metrics that form the backbone of any thriving enterprise, shedding light on how these crucial indicators can forecast financial health, drive strategic decision-making, and unlock the doors to profitability and sustainability.

Whether you’re a seasoned investor, a budding entrepreneur, or simply curious about the financial gears that move the corporate world, this exploration into financial ratios will equip you with the insights needed to navigate the financial landscapes confidently and fully. Join us on this enlightening journey as we decode the significance of financial ratios and transform complex data into actionable wisdom.

Financial Ratios Definition

The financial ratios definition involves quantifiable metrics derived from a company’s financial statements, such as the balance sheet, income statement, and cash flow statement. These ratios measure the relative value of two or more financial figures, providing insight into a company’s performance, financial health, and operational efficiency. They allow a better understanding of a company’s financial situation, and often, banks, investors, and management require them to understand its financial statements. Financial ratios can be calculated based on historical figures but are also widely used as input parameters when building a  financial statement forecast .

Financial ratios analysis involves evaluating these ratios to make informed judgments about a company’s financial condition, operational efficiency, and future performance. This analysis helps investors, creditors, and management understand the company’s strengths and weaknesses by comparing current and past performance and benchmarking against industry averages or competitors. The financial ratios definition is a fundamental practice in financial analysis for trend analysis, strategic planning, and decision-making. It offers a comprehensive view of a company’s financial health and potential for growth and profitability.

Furthermore, the financial ratios definition also involves grouping financial ratios by their purpose as follows:

• Liquidity Ratios
• Efficiency Ratios
• Profitability Ratios
• Growth Ratios
• Leverage Ratios (Bank Ratios)

The Importance of Analyzing Financial Ratios

Analyzing financial ratios is pivotal for stakeholders across various aspects of business operations and decision-making processes. Here’s a breakdown of the importance of financial ratio analysis in different contexts:

Benchmark Financial Ratio Averages by Industry

Analyzing financial ratios against industry averages provides valuable insights into a company’s relative performance. Industries have unique operational characteristics, and financial ratio averages by industry help identify strengths, weaknesses, and competitive positioning. Understanding these nuances by analyzing financial ratios aids in evaluating a company’s efficiency, profitability, and risk management practices against its peers.

Financial Ratio Averages by Industry

Below we included the industry average for the financial ratios of comparable companies with the same industry in which our manufacturing company operates. This gives us a benchmark and allows us to assess how our company performs in comparison to its industry peers.

Funding Requisite

Financial ratios are crucial for assessing a company’s creditworthiness and financial health, which are key considerations for investors and lenders. Ratios related to liquidity, solvency, and profitability inform potential funding sources about the company’s ability to meet its short-term obligations, manage its debt levels, and generate sufficient returns. This analysis supports funding decisions, influencing the terms and availability of external financing.

Market Valuation

Ratios such as price-to-earnings ( P/E ), price-to-book (P/B), and price-to-sales (P/S) are integral in determining a company’s market valuation. Financial ratio averages by industry help investors and analysts gauge whether a stock is undervalued or overvalued relative to its earnings, assets, or sales. Market valuation through financial ratios analysis is essential for making informed investment decisions and assessing the attractiveness of a company’s shares in the stock market.

Performance Management

Analyzing financial ratios internally is a tool for performance management. They enable management to track operational efficiency, financial stability, and profitability over time. By monitoring trends in critical ratios, management can identify areas needing improvement, track the impact of strategic initiatives, and adjust operations or strategy to optimize financial performance.

Strategic Decision-Making

Financial ratio analysis is instrumental in strategic decision-making. It provides a quantitative basis for evaluating strategic options, allocating resources, and pursuing growth opportunities. Ratios related to return on investment (ROI), return on equity (ROE) and return on assets (ROA) inform decisions on investments, expansions, mergers and acquisitions, and other strategic moves, ensuring that such decisions are aligned with the company’s financial goals and shareholder value creation.

Analyzing financial ratios is essential to comprehensively understanding a company’s financial condition and performance. It supports external comparisons, funding decisions, market valuation, internal performance management, and strategic decision-making and is thereby critical to business management’s operational and strategic aspects.

Financial Ratios Cheat Sheet for Financial Ratios Formulas

We have collected a comprehensive list of financial ratio formulas in the form of a financial ratios cheat sheet. These financial ratios formulas can be used as a quick reference guide whenever you need to analyze a company’s health and need the financial ratios definition at hand. Each formula is explained below.

You can download this financial ratio cheat sheet here .

We will now use the financial ratio formulas mentioned in the cheat sheet and follow their definitions to perform our financial analysis. We systematically review the ratios in our five categories: liquidity, efficiency, profitability, growth, and leverage.

Below we present the Financial Statements – Income Statement , Balance Sheet , and Cash Flow Statement of a manufacturing company.  In short, the company generates $5.5m in revenues at an EBITDA margin of 27.6%. Operating cash flow is positive while the company has to invest every year in the maintenance and upgrade of its machinery park. The company also uses Financial Debt which shows up on the Balance Sheet.

To better understand these financial statements, we will calculate all the relevant financial ratios to get a better picture of this company’s financial and performance situation. Our financial analysis will follow the list of financial ratios mentioned in the cheat sheet. We will also need benchmark data of financial ratios by industry so that we can easily compare how our company performs compared to industry peers.

1. Liquidity Ratios

Liquidity ratios measure the capability of the business to pay its obligations, whereas we focus on the current liabilities (liabilities that are due to be paid within one year). Businesses need a certain amount of cash and other current assets to finance the business operation. They assess the company’s capacity to meet its current obligations without requiring additional capital.

The cash ratio is computed by taking the cash and cash equivalents divided by the current liabilities. It measures the capacity of the business to use the most liquid assets to pay short-term obligations. Cash and cash equivalents are the business value in a worst-case scenario in case the other current assets could be converted into cash. Cash equivalents include marketable securities and money market holdings.

In our example, the company has cash & cash equivalents of $1.48 million for the latest year with current liabilities of $0.45 million. The cash ratio computed is 3.3x, which means that the company has more than enough cash & cash equivalent to fulfill the current financial obligation. It shows that the business has excess cash not utilized in operation, which going on since 2018 (when the cash ratio exceeded 1.0x). A minimum cash ratio depends on the industry, but a cash ratio of 0.8x is a reasonable minimum target.

Quick Ratio (Acid-Test Ratio)

The Quick Ratio or the Acid-Test ratio is computed by dividing the Cash & cash equivalents + Receivables (or current assets less inventory) by the current liabilities. Inventory is taken out since it takes more time to dispose of compared to receivables where they normally can be collected quicker. The Quick Ratio is a more conservative approach than the current ratio, and a minimum ratio of 1.0x is desirable for current obligations that can be paid quickly from cash and receivables if needed. There are two financial ratio formulas that can be used:

On our Balance Sheet, the Company has cash & cash equivalent of $1.48 million in 2019, accounts receivable of $0.6 million, and an inventory amounting to $0.6 million for 2019. On the other hand, current liabilities are $0.45 million. It means that the computed Quick Ratio results in 4.6x, which implies that the business has more than enough quick assets to meet its current obligations. Having a high ratio is not a reasonable implication for the business since it does not efficiently utilize its assets and would indicate that the company lacks opportunities to find profitable investments in other ventures.

Current Ratio

The current ratio measures the company’s capacity to meet its short-term liabilities (the liabilities that are due to be paid in one year). The current assets include cash & cash equivalents, accounts receivables, and inventory. The current ratio is computed by taking the current assets divided by the current liabilities. Benchmark ratios depend on the industry, and a manufacturing company’s standard ratio would be somewhere around 2.0x. It would mean there should be around two current assets to pay for one current liability. A lower than one current ratio could mean that the business will have difficulties meeting its short-term obligations and require a cash injection (either from a bank or from shareholders). A higher than two or three current ratios suggest that the company has excess current assets that could be better invested in other ventures (since so many assets are not really needed). The financial ratio definition is as follows:

Based on the balance sheet above, the company has current assets amounting to $2.68 million and current liabilities of $0.45 million in 2019. It means that the current ratio is 6.0x, which is much higher than the desired 2.0x. The business had high current ratios for the past three years. It does not invest the excess current assets and sits idly within the company.

2. Efficiency Ratios

Efficiency ratios measure the efficiency of the business in how to run its operations. The most common efficiency ratios focus on how networking capital is managed and how efficiently assets are being used.

Days Inventory

The inventory days are derived by dividing the inventory by the costs of goods sold (COGS), then multiplied by 365 (the number of days in a year). This efficiency ratio is used to determine how long it takes for the inventory, including the works in progress, into sales. It also measures the company’s efficiency in terms of warehousing, distribution, and the timing of purchasing new inventory. The shorter the inventory days, the better since it implies that the business can produce another production cycle.  

The average inventory amounts to $0.60 million, and the costs of goods sold amounted to $2.60 million in 2019. Both inventory and COGS have increased throughout the years. Given the figures above, the computed days in inventory are 84 days, which can be considered a high ratio compared to the industry average of 50 days as calculated in the financial ratios by industry. It means that the company stocked up inventory for almost three months before it disposed of it and turned it into cash. The day’s inventory needs to be improved. As the Days Inventory was already reduced from 2018 (91 days) to 2019 (84 days), most likely, efforts were initiated but not enough to meet competitors’ standards.

Days Receivables

The day’s receivables (or days sales outstanding) are the average number of days it takes for the accounts receivable to be collected. It depicts the company’s efficiency in collecting payments from its customers. The faster payment can be collected, the more cash is available for day-to-day operations. The targeted day’s receivables vary from industry to industry but should be near the average credit terms provided for the company’s customers. As per the financial ratio definition, days receivables are computed by dividing the accounts receivable over net sales, then multiplied by 365 days.

Given the accounts receivable of $0.60 million and net sales of $5.50 million for 2019, the calculated day’s sales outstanding is 40 days. The turnover has decreased in the past three years, 58 days in 2017 and 45 days in 2018, respectively, suggesting that the collection system has improved. If we compare to the industry average (50 days), the company (40 days) now actually manages receivables more efficiently than its peers. This would be a sign of good management.

Days Payables

Days Payables is computed by dividing the accounts payable by COGS, then multiplied by 365 to get the length of time it takes for the company’s bills and financial obligations to be paid. Desirable days payable depend on industry standards and good relationships with creditors. A low ratio can indicate that the business applies shorter credit terms than its competitors or that it is not fully utilizing the terms offered by creditors. On the other hand, the high ratio suggests that the company has better credit terms than its competitors or has limited ability to pay the current obligations on time. A high ratio can be beneficial, given that the company can use the cash for other activities such as investment. However, it can jeopardize the business’s credit rating and lead to higher purchasing costs when suppliers realize that their invoices do not get paid in time. 

The accounts payable for 2019 are $0.45 million, and the COGS is $2.6 million, translating to 63 days of turnover. Days payable outstanding for 2017 and 2018 are 47 days and 55 days, respectively. Either the company is in a favorable position to demand longer credit terms, or, in some cases, it would indicate that the company is using payables to finance its operation. Also, our analysis of financial ratios by industry shows that the days payable are longer than the industry average of 30 days.

Cash Conversion Cycle (CCC)

The cash conversion cycle measures how fast the inventory turns into cash. It includes the working capital accounts, which are the inventory, receivables, and payables. The day’s inventory and receivables are added, and then the days payable are used to compute the cash conversion cycle. The shorter the CCC, the better since more products can be sold in a particular time and then produce another production cycle.

As computed above for the year 2019, days inventory is 84 days, days receivable is 40 days, and the days payable is 63 days. It translates to 61 CCC, which means that it takes 61 days to purchase inventory, sell products on credit, collect cash, and pay outstanding payables. It is higher than the industry benchmark of 55, which means that the cash conversion cycle should be improved.

Asset Turnover Ratio

Asset turnover is an indicator of how efficient the company is in using assets to produce sales. It is computed by taking revenues and then dividing them by the total assets. Higher ratios indicate that a company uses its assets more efficiently to generate revenues. Conversely, lower ratios than competitors need further investigation and analysis to determine how the company can utilize the assets properly to produce more output that turns into sales.

For 2019, the company recorded net sales of $5.5 million and the value of its total assets of $4.98 million. It provides an asset turnover ratio of 1.1x, which means that per dollar of assets, $1.1 in revenue can be generated. This is a good indicator that the business is appropriately utilizing its assets to generate more sales.

Effective Interest Rate

The effective interest rate is the effective interest rate paid by the company’s interest-bearing debt, taking into account all effects, including eventual compounding. It means that the more frequent the compounding period, the higher the effective interest rate. A higher effective interest rate is profitable for the lender but more interest to pay on the debtor. The interest payment is divided by the average interest-bearing financial debt to compute the effective interest rate. 

In our example, the company has paid interest amounted to $48K for 2019 and financial debt of $2.5 million and $2.0 million for 2018 and 2019, respectively. With the given figures, the computed effective interest rate is 2.1%. A low-interest rate indicates that using debt financing benefits the company as much as the interest is cheap. A high-interest rate would indicate that using debt financing adds significant stress on the company and, therefore, might require de-leveraging.

Effective Tax Rate

The effective tax rate is the average tax rate paid by a company. It is computed by taking the tax paid divided by earnings before tax (EBT). Investors and analysts use this ratio to analyze business efficiency in generating income and how much is allocated from earnings to pay for tax obligations.

Considering that the company’s tax obligation for 2019 is $30K and the EBT is $1.25 million, this translates to a 2% effective tax rate for the corresponding year. It means that the tax obligation is only a small percentage of the business cash outlays and doesn’t affect the earnings.

3. Profitability Ratios

Profitability ratios evaluate the company’s capacity to generate profits relative to its revenue, assets, cash flow, and equity. These ratios are the financial ratio formulas most looked at by investors since they tell them how much they can earn by investing in the company. The higher the profitability, the better.

Gross Profit Margin

It is computed by taking the gross profit and dividing it by net sales. This ratio entails how effective the company is in earning profit after deducting the cost of goods sold or the service industry’s revenue costs. A high gross profit margin shows that the business can sufficiently cover its direct costs (direct expenses when producing goods and services).

The Company shows net sales of $5.5 million for 2019 and 2.9 million in gross profit. This results in a gross profit margin of 52.7% percent. It means that only 47.3% is spent on COGS. A 52.7% gross profit margin is considered a high margin compared to industry standards.

EBITDA Margin

EBITDA is the earnings after deducting all production costs and operating expenses, excluding interest, taxes, depreciation, and amortization. The EBITDA margin is derived by taking EBITDA and then dividing it by net sales. It is more comparable to using with competitors since it only considers the operating costs on a cash basis, which can be similar to the competitors.

The company generates an EBITDA of $1.52 million for 2019 from a $5.50 million net sale. The EBITDA margin is computed at 27.6%. It can be considered a higher return compared to the industry average of 15%, per the industry analysis. Also, many other industries show EBITDA margins between 10% – 15%.

Net Profit Margin

Production costs, general and administrative expenses, interest expenses, taxes, and depreciation are deducted to derive net income, which is then divided by net sales. Though this ratio could be a valuable tool for internal use to assess how much is left after removing all the costs, the net profit margin is not a fair comparison with competitors since businesses have different financing structures. 

Considering a net income of $1.22 million for 2019 after deductions of all expenses from the net sales of $5.50 million, the company’s net profit margin translates to 22.2%. The company’s net profit margin has been increasing for the past three years, 14.1% and 19.7% for 2017 and 2018, respectively. Increasing net profit margins show the stability of business earnings.

Return on Assets

The return on assets is derived by taking the net income + interest divided by the average assets. It measures the business’s efficiency in generating profit by optimizing its assets. The return on assets is a valuable ratio in evaluating asset-intensive companies such as telecom and car manufacturers since it assesses if they are correctly utilizing their assets to generate more profit. The financial ratio definition is as follows:

In 2019, the Company had a $1.22 million net income with an interest obligation of $48K. The assets of 2019 ($4.98 million) and 2018 ($4.14 million) led to an average asset position of $4.56 million. With these figures, the return on assets is computed at 27.9%. It can be assessed that the business is appropriately utilizing its assets to produce desired earnings.

Return on Equity

The return on equity is looked at from the shareholders’ point of view and is computed by dividing the net income by the average shareholders’ equity. The higher the return, the better it is for the investors since profits can either be used to pay higher dividends or reinvested to grow the business. It also shows how effective the company is in utilizing its equity to produce earnings.

The Company’s net income was $1.22 million in 2019, while shareholders’ equity was $1.31 million and $2.53 million for 2018 and 2019, respectively. The computed return on equity is 63.7%, which means that every dollar of equity produces 64 cents. Therefore, the Company is appropriately utilizing the investors’ money to pay back dividends.

Return on Capital Employed

Return on capital employed measures how efficiently the company uses the capital employed in its operations, including net debt and equity, to produce earnings. It is computed by taking the Net Operating Profit Less Adjusted Taxes (NOPLAT), which is the same as EBIT adjusted for Pro-forma taxes, divided by the average capital employed. Capital employed is the amount of total capital invested in the business to use for the business operation and generate profit. It is calculated by adding Net Working Capital minus Cash plus Fixed Assets, which is the same as Net Debt + Equity.

The return on capital employed is a more meaningful profitability ratio to assess business performance since it considers both the capital invested by shareholders and debtors. The financial ratio formulas are the following:

Considering 2019, the company shows a NOPLAT of $1.29 million ($1.30 million EBIT—2% tax rate). Capital employed amounted to $2.77 million (2018) and $3.05 million (2019), averaging at $2.91 million. The resulting return on capital employed (ROCE) is 43.6% for 2019. This is much higher than any reasonable opportunity costs on the invested capital and shows excellent operating profitability of the company.

4. Growth Ratios

Growth ratios typically serve as an additional metric to determine a company’s success by measuring its ongoing growth rates. Successful companies usually keep growing, while those that stagnate or do not grow end up in trouble. Therefore, as a financial analyst, you want to understand if a company keeps growing and why.

Revenue Growth

Revenue growth , a metric presented as a percentage, is used to measure if the company is growing over time. An increasing trend means that the business is continually growing, while a decreasing rate could suggest an operational problem related to the sales department or the industry it belongs to is already slowing down. On the downside, this ratio excludes costs in the computation, which means it does not present the actual picture of the company’s operations and profits. To compute the revenue growth, divide the current revenue by the revenue of the previous period, and subtract one.

In our example, the Company’s revenue growth has been increasing for the past three years, which recorded 18.4% and 22.2% for 2017-2018 and 2018-2019, respectively. It means that the company is continually growing and also clearly exceeds the 5.0% annual revenue growth as per the analysis of financial ratios by industry.

EBITDA Growth

EBITDA growth is a good measure of profitability compared to its competitors and industry average as it takes into account the operating costs or cash flows in the analysis.  Increasing EBITDA shows that the effect of cost-cutting efforts done by the company is working. An interesting situation is when revenue keeps growing but not EBITDA. It means one has to analyze the costs better as it can be costly to achieve further growth. Important then is to understand if the costs spent are likely to lead to higher profits later on or not. To compute the EBITDA growth, divide the current EBITDA by the EBITDA of the previous period and subtract one.

The Company’s EBITDA Growth decreased over the last two years, from 46.9% for 2017-2018 to 27.7% for 2018-2019. Maintaining continuous high EBITDA growth is difficult. Still, management needs to identify the reasons for the high growth and seek ways to maintain it.

Net Income Growth

Net income growth measures a company’s growth using the earnings found from the income statement’s bottom level. Comparing net income to EBITDA and revenue growth rate can give indications of where a company’s problem starts. However, this is not a fully fair comparison to competitors and industry average since companies across the industry have different financial structures that impact Net Income (but not EBITDA). To compute the net income growth, divide the current Net Income by the Net Income of the previous period and subtract one.

The Company’s Net Income growth decreased from 65.4% to 37.7% in the last two years. As EBITDA already decreases according to the same pattern, we conclude that the reason must lie above the EBITDA line. The company uses debt financing, which leads to interest costs, which impact Net Income more heavily (as interest costs behave as fixed costs in this case).

Asset Growth

Asset growth is a metric used to assess how much the assets grow for the evaluated years. Increasing growth can be an indication of a company’s growth and stability. However, decreased or fluctuation needs further analysis, for it does not necessarily mean a losing business since the timing of asset sales or purchases can affect the result. To compute the asset growth, divide the current period’s Total Assets by the Total Assets of the previous period, and subtract one.

Asset Growth decreased during the past two years from 31.3% to 20.4%. The Asset Growth rate declined a bit as the Asset Turnover ratio became less efficient (1.1x instead of 1.2x). The reason lies also in the company’s cash balance which was steadily increasing over the last years and leading to a higher base to measure asset growth.

Equity Growth

Equity growth measures the growth in the company’s equity position recorded for the evaluated period. Investors use this metric to determine whether the company’s total equity is growing and whether the growth can be maintained. To compute the equity growth rate, divide the current period’s Equity value by the Equity book value of the previous period and subtract one.

The equity growth rate has decreased over the past two years. Equity growth for 2017-2018 was 211.3% but then decreased to 93.5% for 2018-2019. This is due to the fact that the equity position at the beginning was very thin, so it is easy to grow, and afterward, no Dividends are paid, leaving all income earned inside the company.  

5. Leverage Financial Ratios (or Bank Ratios)

Leverage or Bank ratios are used to evaluate a business’s capacity to pay its debt. Banks and other creditors evaluate them to ensure that the company asking for a loan will meet its obligations when due.

Leverage ratios examine the company’s capital structure by assessing its total assets, liabilities, and shareholders’ equity. They also uncover how heavily a company is funded by debt. Using a high amount of leverage makes a company vulnerable to financial risks. Certain stability in the business’ cash flow generation is required to service its financial debt, as any business turmoil can put the company in severe difficulties.

Debt/EBITDA Ratio

The financial ratio formula is computed by considering the company’s interest-bearing debt (or financial debt which only includes debt with interest and financing character but not payables or provisions even despite the term debt is used) which is then divided by the EBITDA (the Earnings before Interest, Tax, Depreciation, and Amortization). The Debt/EBITDA ratio is used to measure the capability of paying financial debt out of the cash earnings available to the company. A low Debt/EBITDA ratio of less than 1.5x normally means that the company can easily cover its financial debt obligations. Based on its EBITDA, it would take only 1.5x years to repay the debt. As with any other ratio of relevance to the bank, this impacts the company’s credit score. In contrast, a high Debt/EBITDA ratio > 3.0x implies that the business, in the worst case, will require more than 3 years to repay the financial debt from EBITDA. Such high ratios normally serve as a warning sign to lenders as they might start to question the company’s ability to repay its debt. Below is the financial ratio definition:

For 2019, the company’s interest-bearing debt amounts to $2.0 million, with an EBITDA of $1.52 million, translating into a 1.3x Debt/EBITDA ratio. It portrays that the business uses only a modest amount of financial debt, which is also lower than the industry average of 2.0x.

Net Debt/EBITDA Ratio

The Net Debt/EBITDA ratio is computed by taking the interest-bearing debtless cash and dividing this number by EBITDA. It is a bank ratio that measures how many years it takes for the company to pay its debt, given that the net debt and EBITDA are constant. Having more cash, however, would render the ratio negative. A high ratio indicates that the business will not be able to pay all its financial obligations.

As mentioned above, the company’s interest-bearing debt amounts up to $2.0 million for 2019, cash & cash equivalents of $1.48 million, and EBITDA of $1.52 million. It means that the business has a net debt ratio of 0.3x. The Net Debt/EBITDA ratio normally is lower than the Debt/EBITDA ratios due to the assumption that the cash on the Balance Sheet could be used to repay some of the debt.

Interest Coverage Ratio

The interest coverage ratio measures the company’s ability to pay its interest obligation. Bankers and other creditors examine this leverage ratio to determine how much they can lend to the company. The calculation of the interest coverage ratio is derived by dividing EBIT by the interest expense.  

On the income statement for 2019 above, EBIT is $1.3 million, and the interest expenses amount to $48K. The computed interest coverage ratio is 27.1x, which is significantly higher than the minimum threshold, such as 1.5x or 3.0x, that a bank could require. This ratio is consistent with the view that our example company only uses a modest amount of financial debt financing.

Debt Service Coverage Ratio

The debt service coverage ratio is computed by taking the free cash flow to the firm (FCFF) and then divided by the debt repayment + interest. FCFF is the operating cash flow after accounting for taxes, changes in working capital, and CAPEX. A high debt service ratio means there is enough available FCFF to service the loan’s interest payment and principal repayment obligations. The financial ratio formula is as follows:

Considering that FCFF available in 2019 is $0.77 million, and the debt service amounted to $0.55 million. The company has a Debt Service Coverage Ratio (DSCR) of 1.4x. This might come dangerously close to any reasonable threshold expected by a bank of 1.25x or 1.50x. However, the current year’s debt repayment component seems abnormally high, and also the company has still significant cash on the Balance Sheet. Another reason could be that the CAPEX (which impacts FCFF heavily) is influenced by one-time costs. Nevertheless, the company will have to investigate this and ensure a next year’s DSCR ratio increases either by repaying less or producing more Free Cash Flows to the Firm.

The debt ratio measures how much of the total assets are financed through debt and indicates the financial ratio’s leverage effect. It is computed by taking the total liabilities and dividing them by the total assets. A high debt ratio suggests that the business is mostly funded by debt and uses high financial leverage.

For 2019, the current liabilities are $0.45 million and non-current liabilities of $2 million, while the total assets amounted to $4.98 million. It shows that the debt ratio is only 0.5x, which depicts that the company is not highly leveraged. The debt ratios have also gradually decreased for the past three years, which portrays that total assets are financed less and less by liabilities.

Debt/Equity Ratio

The debt/equity ratio aims to determine the % of debt financing used in a company’s financing sources. It is computed by taking the interest-bearing debt and divided by the total shareholders’ equity. It is a calculation of how much the borrowed capital is for the investment. Also, it entails the capacity of the company to cover its debt through the owner’s equity. The financial ratio formula is defined as follows:

The company borrowed a total of $2.0 million for 2019, and its total equity in the same year amounted to $2.53 million. The Debt/Equity ratio for the company of 79.1% is low, and the equity can cover the debt. It can also suggest that the business is not in a capital-intensive industry since this industry can have as high as two hundred percent debt/equity ratios. Also, the company can maintain low borrowing, which should allow for avoiding adverse effects during business turmoil.

We are now all set to interpret our results using the financial ratio definitions in our cheat sheet and the industry benchmarks. This allows us to include a financial ratio comparison analysis when seeking to understand financial statements .

What Does Our Financial Ratios Analysis Tell Us?

As we worked through the financial ratios list to perform a comprehensive financial ratios analysis of our company’s situation, we now can obtain the full picture of what is going on. Here is the conclusion based on our analysis of the calculated financial ratios:

• Liquidity : For liquidity ratios, the Current Ratio (6.0x), Quick Ratio (4.6x), and Cash ratio (3.3x), all the results show that the company has more than the required current assets to cover its current liabilities. Current obligations can be easily met with the available current assets. The ratios would even indicate that there are excess funds available that could be invested outside the business to gain additional income in order to avoid sitting idle in the business.
• Efficiency : Days inventory (84 days) indicates a long period of goods that must remain in inventory. When comparing to industry benchmarks of 50 days, the company has to work things out to lower the inventory turnover to the benchmark level or near it. Days sales outstanding (40 days) seem to be close to the benchmark of 35 days, but some attention is required as the ratio exceeds the benchmark.  On the other hand, days payables (63 days) increased over the last three years, which entails low turnover ratios, which can be interpreted as abusing the goodwill of the company’s suppliers and most likely will not be sustainable in the future. However, low turnover for days payables can benefit the business at the moment since the resources can still be utilized for the operation and prospective investment. Overall, there is some work to do here as our company needs to assess how to improve and lessen its working capital turnover.
• Profitability : In terms of profitability ratios, the gross profit margin is computed at 52.7%, the EBITDA margin is 27.6%, and the net profit margin is 22.2%. All these margins indicate exceptionally high profitability and strong value capture ability by the company. The company must sell something valuable as the EBITDA margins clearly outrank the available industry average of 15.0%. Also, this is reflected in other profitability ratios such as the return on assets (27.9%), return on equity (63.7%), and return on capital employed (43.6%). Important to note here is that the main reason the last three ratios are so high is the high profit margins, as clearly, the company is not operating as efficiently as its peers in terms of managing its working capital.
• Growth : Revenue growth increased from 18.4% (2018) to 22.2% (2019). However, EBITDA growth slowed down (46.9% to 27.7%), and the same is true for net income growth (65.4% to 37.7%), as it is more difficult to grow a larger starting base than a lower one. The same is true for asset growth from 31.3% (2018) to 20.4% (2019), and equity growth of 211.3 (2018) to 93.5% has a decreasing trend for the last three years. Overall, the point is that the company continues to experience strong growth and will most likely continue to grow strongly in the future, exceeding the growth rates in the industry’s average financial ratios.
• Leverage :  Several financial leverage ratios, including Debt/EBITDA ratio (1.3x), Net Debt/EBITDA ratio (0.3x), interest coverage ratio (27.1x), Debt ratio (0.5x), and the Debt/Equity ratio (79.1%) would argue that the company uses a modest degree of bank financing and cannot be considered as highly leveraged. The financial ratio leverage appears modest. There is one question mark with respect to the Debt Service Coverage Ratio (1.4x), which becomes dangerously low compared to expected bank covenants, which normally lie at around 1.25x-1.50x. The reason there was a large repayment of $500,000 or eventually a large one-time investment, which led to high CAPEX in the last years. This will require further analysis with respect to the reasons why, and also, one needs to determine how the ratio will result in the next year to avoid any surprises. 

It is also important to note that the financial ratios by industry are very helpful in better analyzing and interpreting the company’s financial situation. This helps to put the calculated financial ratios in perspective and allow conclusions as to where further improvements should be possible in light of the competitors’ performance.

Making good use of our financial ratios list helps us perform a comprehensive financial evaluation of the company. This allows us to identify problems better and also helps us enhance the quality of our budgets and forecasts.

Please refer also to our rich collection of financial model templates which include tons of comprehensive financial ratio analyses for countless types of businesses. The spreadsheet model templates are frequently used by entrepreneurs from many countries, including the United States, Canada, Brazil, Mexico, Colombia, United Kingdom, Germany, France, Spain, Italy, Switzerland, Belgium, Portugal, Sweden, Norway, Saudi Arabia, China, India, Indonesia, Australia, New Zealand, Japan, and many other countries. Feel free to download our financial ratios cheat sheet which can serve as a great reference when you are in need of the financial ratios’ definitions.

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10 Financial Ratios Every Small Business Owner Should Know

Janet Berry-Johnson, CPA

Reviewed by

July 15, 2022

This article is Tax Professional approved

Are you just starting out as a business owner? Or a seasoned entrepreneur who wants to take your company to the next level of growth? Either way, tracking financial ratios can help you analyze your company’s financial position and help you make more informed business decisions.

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Of course, there are dozens—if not hundreds—of potential financial ratios to track. So which ones are most important for you? This article will help you decide.

Why are financial ratios important?

Financial ratios are important because they give business owners a way to evaluate financial performance beyond financial statements and compare it to similar businesses in their industry.

Your balance sheet , income statement, and cash flow statement are helpful, but they offer only limited insight. Financial ratios go beyond the numbers to reveal how efficiently your company is at funding itself, making a profit, growing through sales, and managing expenses. They can also provide a warning sign that things aren’t working, letting business owners and managers know when to make a change.

Most important financial ratios

There are dozens of financial ratios you can track, but the most important financial ratios fall into one of four broad categories:

• Profitability
• Asset management

We’ll look at 10 ratios across these four categories and provide a detailed walkthrough for each.

Liquidity ratios

Liquidity is a measure of your business’s ability to cover its short-term obligations, such as accounts payable, accrued expenses, and short-term debt. When a company has liquidity troubles, it may have trouble paying employees and suppliers and covering other daily operating expenses, leading to big problems.

Liquidity ratios typically compare the company’s current assets (cash, inventory, and receivables) with current liabilities.

1. Current ratio

Your current ratio , also known as your working capital ratio, estimates your ability to pay short-term obligations—liabilities and debts due within one year.

Current Ratio = Current Assets / Current Liabilities

Ideally, your current ratio will be greater than one, meaning you can settle every dollar owed for payables, accrued expenses, and short-term debts with your existing current assets.

2. Quick ratio

Your quick ratio, also known as your acid test ratio, is similar to current ratio in that it’s a gauge of your business’s ability to pay its debts. However, it looks at only the company’s most liquid assets (cash, marketable securities, and accounts receivables) rather than all current assets. It excludes prepaid expenses because you can’t use them to pay other short-term liabilities and excludes inventory because it could take too long to convert to cash.

Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

A quick ratio above 1 means your business has enough liquid assets to cover short-term obligations and maintain your operations.

3. Days of working capital

Days working capital indicates the number of days required to convert your working capital into sales.

Days Working Capital = ((Current Assets - Current Liabilities) x 365) / Revenue from Sales

A high days working capital number means that your company takes longer to realize cash from its working capital. Companies with lower days working capital have less need for financing because they make efficient use of working capital.

The best way to evaluate your result is to compare it with those of other companies within the same industry.

Leverage ratios

Leverage is the amount of debt your company has in its capital structure, which includes both debt and shareholders’ equity. A company with more debt than average for its industry is considered highly leveraged.

Being highly leveraged isn’t necessarily a bad thing. A growing company might take advantage of low interest rates to seize market opportunities. Being highly leveraged could be a smart business decision as long as the company can comfortably afford to make debt payments. However, companies that struggle to make debt payments may fall behind and not be able to borrow additional money to stay afloat.

4. Debt to equity ratio

Your debt to equity ratio compares total debt to total equity to measure the riskiness of the company’s financial structure. Lenders and other creditors closely monitor this metric, as it can provide an early warning sign when companies are taking on too much debt and may have trouble meeting payment obligations.

Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity

A good debt to equity ratio varies by industry. A ratio around 2 or 2.5 is generally considered good for most companies. That means that for every dollar shareholders invest in the company, about 66 cents comes from debt while the other 33 cents come from equity.

However, companies with consistent cash flows might be able to sustain a higher ratio without running into problems.

5. Debt to total assets

Your debt to total assets ratio tells you the percentage of your company’s assets financed by creditors.

Debt to Total Assets = Total Debt / Total Assets

Companies with high debt to total assets ratios are risky to invest in because the company has to pay out a higher percentage of its profits in principalle and interest payments than a similar-sized company with a lower ratio.

Most investors prefer to put their money into companies with a debt to total assets ratio below 1. This shows the company has more assets than liabilities and could pay off its debts by selling assets if needed.

Profitability ratios

Profitability ratios evaluate your ability to generate income (profit) and create value for shareholders.

6. Profit margin

Your net profit margin ratio measures the amount of net income earned with each dollar of sales generated by the company. In other words, it shows what percentage of sales is left over after paying all business expenses.

Profit Margin Ratio = Net Income / Net Sales

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 , like this one from the NYU Stern School of Business.

7. Return on assets

Return on assets (ROA) indicates how well your company is performing by comparing your profits to the capital you’ve invested in assets. The higher the ROA, the more efficiently you use your economic resources.

Return on Assets = Net Income / Average Total Assets

While comparing your ROA to other companies in your industry is helpful, it’s more helpful to look at how your return on assets changes over time. If this metric rises from year to year, it generally indicates that you’re squeezing more profits out of each dollar of assets on the balance sheet. However, if your ROA is declining, it could mean you’ve made some bad investments.

8. Return on equity

Your return on equity (ROE) measures the company’s ability to generate profits from shareholder investments into the business.

Return on Equity = Net Income / Shareholders’ Equity

A good ROE depends on your industry. For example, according to the NYU Stern School of Business , the ROE for electronics companies averages around 44%, while engineering and construction companies average just above 6%.

Asset management ratios

Asset management ratios analyze how efficiently a company uses its assets to generate sales. The following ratios are normally only used by businesses that carry inventory or sell to customers on credit.

9. Inventory turnover

Your inventory turnover ratio measures how efficiently you manage inventory.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

When evaluating your inventory turnover ratio, compare your metric to companies operating in the same industry. A low inventory turnover ratio compared to the industry average can indicate that your sales are poor or you’re carrying too much inventory.

10. Receivables turnover

Receivables turnover measures how quickly you collect sales made on credit.

Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable

Determining whether your receivables turnover ratio is good or bad involves comparing your metrics to your company’s credit policies and payment terms. For example, if your credit terms allow customers to pay invoices within 30 calendar days but your receivables turnover shows that it’s averaging 45 days to collect payments, you may have a problem with extending credit to customers who aren’t able to pay or need to tighten up your collection processes.

On the other hand, if you have a Net 60 policy, collecting payments within 45 days means you’re exceeding your goals.

How Bench can help

These key financial ratios are essential analysis tools that business owners can use to quickly evaluate your company’s profitability and performance. By tracking these metrics over time, you can spot risks before they become problems and make changes to improve your bottom line.

Of course, it all starts with solid bookkeeping. Bench helps you stay on top of your company’s performance by giving you all the information you need to calculate important financial ratios.

Each month, your transactions are automatically imported into our platform and categorized and reviewed by your personal bookkeeper. Explore our platform with a free tour today .

Further reading: How to Calculate and Use Year-over-Year (YoY) Growth

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Financial Ratios Analysis

When developing financial projections for your business plan it is useful to monitor the financial ratios produced so that they can be compared with other available data. By making the comparisons it is possible to see whether your financial projections are in line with industry, competitor, and if available, historical data. If the financial ratio comparisons reveal unexplained variations then the assumptions in the plan need to be improved and fine tuned to bring the projections in line with expectations.

What are Financial Ratios

One financial ratio viewed in isolation will not tell you a great deal about a business. The key to using financial ratios is to chose the ratios which are most critical to your business, decide on the formula to use, which should be the same as that used by comparable businesses in your industry, and consistently monitor the ratio over time relative to other ratios you have calculated.

Key Financial Ratios

Financial ratios can be split into six main categories

• Profitability Ratios
• Liquidity Ratios
• Efficiency ratios
• Leverage Ratios
• Activity ratios
• Investor ratios

Profitability Financial Ratios

The profitability ratios are used to measure the ability of a business and its management to generate profit and the following financial ratios are included and calculated for you in the financial projections template:

• Gross margin percentage
• Operating expenses ratio
• Return on sales
• Net profit ratio
• Return on capital employed (ROCE)

Profitability Ratio Example – Gross margin Percentage

The numbers used in the calculation of the gross margin percentage are highlighted in the income statement shown above.

Efficiency Financial Ratios

Efficiency ratios are used to measure the ability of a business to control and manage its assets to produce the maximum amount of revenue and profit from them. The following financial ratios are included and calculated for you in the financial projections template:

• Asset turnover ratio
• Fixed asset turnover ratio
• Working capital turnover ratio

Efficiency Ratio Example – Asset Turnover Ratio

The asset turnover ratio shows the revenue generated by the assets of your business. It is a measure of the efficiency with which the business uses its resources. It is calculated by dividing revenue by assets

The numbers used in the calculation of the gross margin percentage are highlighted in the income statement and balance sheet shown above.

Liquidity Financial Ratios

A liquidity ratio is used to measure the ability of a business to generate cash to meet its short term liabilities and debts. The following financial ratios are included and calculated for you in the financial projections template:

• Current ratio
• Quick ratio

Liquidity Ratio Example – Current Ratio

The current ratio measures the liquidity of a business and its ability to meet its short term liabilities and debts. It is calculated by dividing current assets by current liabilities.

The numbers used in the calculation of the current ratio are highlighted in the balance sheet shown above.

Leverage Financial Ratios

A leverage ratio is used to show the capital structure of the business and in particular the level of debt in relation to owners equity. A business with a high level of debt is considered to be more risky but will give greater returns to the owners provided cash and profit are managed correctly. The following financial ratios are included and calculated for you in the financial projections template:

• Gearing ratio
• Debt equity ratio
• Times interest earned

Leverage Ratio Example – Debt Equity Ratio

The debt equity ratio is the ratio of how much a business owes (debt) compared to how much the owners have invested (equity). It is calculated by dividing debt by owners equity.

The numbers used in the calculation of the debt equity ratio are highlighted in the balance sheet shown above.

Note in this example there is only long term debt shown in the balance sheet, in practice all forms of debt should be included in the calculation.

Leverage ratios assess a businesses ability to pay off long-term debt including obligations to creditors, bondholders, and banks and for this reason are sometimes referred to as solvency ratios .

Activity Financial Ratios

Activity ratios are used to measure the ability of a business to convert different balance sheet accounts such as inventory, accounts receivable, and accounts payable into cash or sales. The following financial ratios are included and calculated for you in the financial projections template:

• Accounts receivable days ratio
• Accounts payable days ratio
• Inventory days

Activity Ratio Example – Accounts Receivable Days Ratio

The accounts receivable days ratio shows the average number of days your customers are taking to pay you. It is calculated by dividing accounts receivable by average daily sales.

Note: In this example the closing balance sheet is used to obtain the value of accounts receivable. If available, it is good practice to use values from both the opening and closing balance sheets to give an average value fro accounts receivable.

Investor Financial Ratios Analysis

Investor ratios are used to measure the ability of a business to earn an adequate return for the owners of the business. The owners have money tied up in the business and need a return commensurate with the risk involved. The following financial ratios are included and calculated for you in the financial projections template:

• Return on Equity (ROE)
• Dividend cover

Investor Ratio Example – Return on Equity (ROE)

The return on equity measures the percentage rate of return the owner of a business gets on their investment. It is calculated by dividing the net income by the owners equity.

The numbers used in the calculation of the return on equity are highlighted in the income statement and balance sheet shown above.

Financial ratios are derived from information included in the income statements and balance sheets of the business plan financial projections. The ratios are used as indicators of the the financial health of the business and for comparing the performance of the business with other businesses in the same sector, and can be used to fine tune the financial projections.

When the financial projections have been prepared, equity investors , providers of debt finance, and many trade credit suppliers will use financial ratios analysis to assess the business to decide whether or not to invest, provide loan facilities or to extend credit to the business.

About the Author

Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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12.1: Introduction to Ratio Analysis

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• Henry Dauderis and David Annand
• Athabasca University via Lyryx Learning

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Learning Objectives

• LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.

A common way to evaluate financial statements is through ratio analysis . A ratio is a relationship between two numbers of the same kind. For example, if there are two apples and three oranges, the ratio of the number of apples to the number of oranges is 2:3 (read as "two to three"). A financial ratio is a measure of the relative magnitude of two selected numerical values taken from a company's financial statements. For instance, the gross profit percentage studied in Chapter 6, also known as the gross profit ratio, expresses the numerical relationship between gross profit and sales. If a company has a gross profit ratio of 0.25:1, this means that for every $1 of sales, the company earns, on average, $0.25 to cover expenses other than cost of goods sold. Another way of stating this is to say that the gross profit ratio is 25%. 1

Financial ratios are effective tools for measuring the financial performance of a company because they provide a common basis for evaluation — for instance, the amount of gross profit generated by each dollar of sales for different companies. Numbers that appear on financial statements need to be evaluated in context. It is their relationship to other numbers and the relative changes of these numbers that provide some insight into the financial health of a business. One of the main purposes of ratio analysis is to highlight areas that require further analysis and investigation. Ratio analysis alone will not provide a definitive financial evaluation. It is used as one analytic tool, which, when combined with informed judgment, offers insight into the financial performance of a business.

For example, one business may have a completely different product mix than another company even though both operate in the same broad industry. To determine how well one company is doing relative to others, or to identify whether key indicators are changing, ratios are often compared to industry averages . To determine trends in one company's performance, ratios are often compared to past years' ratios of the same company.

To perform a comprehensive analysis, qualitative information about the company as well as ratios should be considered. For example, although a business may have sold hundreds of refrigerators last year and all of the key financial indicators suggest growth, qualitative information from trade publications and consumer reports may indicate that the trend will be towards refrigerators using significantly different technologies in the next few years. If the company does not have the capacity or necessary equipment to produce these new appliances, the present positive financial indicators may not accurately reflect the likely future financial performance of the company.

An examination of qualitative factors provides valuable insights and contributes to the comprehensive analysis of a company. An important source of qualitative information is also found in the notes to the financial statements, which are an integral part of the company's financial statements.

In this chapter, financial ratios will be used to provide insights into the financial performance of Big Dog Carworks Corp. (BDCC). The ratios will focus on financial information contained within the income statement, statement of changes in equity, and balance sheet of BDCC for the three years 2019, 2020, and 2021. This information is shown below. Note that figures in these statements are reported in thousands of dollars (000s). For consistency, all final calculations in this chapter are rounded to two decimal places.

Assume that 100,000 common shares are outstanding at the end of 2019, 2020, and 2021. Shares were issued in 2020, but at the end of year the number of outstanding shares was still 100,000.

There are four major types of financial ratios: a) liquidity ratios that measure the ability of a corporation to satisfy demands for cash as they arise in the near-term (such as payment of current liabilities); b) profitability ratios that measure various levels of return on sales, total assets employed, and shareholder investment; c) leverage ratios that measure the financial structure of a corporation, its amount of relative debt, and its ability to cover interest expense; and d) market ratios that measure financial returns to shareholders, and perceptions of the stock market about the corporation's value.

Initial insights into the financial performance of BDCC can be derived from an analysis of relative amounts of current and non-current debt. This analysis is addressed in the following sections.

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How to Calculate Ratios for a Financial Plan

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6. RATIO ANALYSIS

The next analysis appearing in the financial plan should be your Forecasted Ratio Analysis. In a nutshell, Ratio Analysis is a general technique for analyzing the performance of an existing or potential business.

Ratios involve dividing numbers from the Balance Sheet and Income Statement to create percentages and decimals. When aspiring entrepreneurs and existing business owners apply for a loan, for example, bankers usually look at their forecasted ratios and compare them to ratios of other businesses operating within the same industry.

Your projected ratios should be calculated over a three year forecasted period. Many business plan writers calculate the ratios and provide a narrative discussion, depicting how each has changed over the three year forecasted period. Others calculate the ratios and provide a footnote stating "a complete analysis regarding the forecasted ratios is available upon request. Yet other business plan writers feel the need to calculate various ratios and compare them to ratios of other businesses within the industry. The later approach can be time consuming and may not be "cost effective". Below provides an example of J&B's forecasted Ratio Calculations.

The information provided in the above example depicts the name of each ratio, the formula required in calculating each ratio, the dollar amounts for each formula item, and the ratio calculation for each of the forecasted years. It is important to stress that these dollar amounts have been taking from J&B's forecasted Balance Sheet and Forecasted Income Statement. Therefore, the forecasted balance sheet and income statement must be complete before forecasted ratios can be calculated.

Also notice:  J&B decided to calculate the ratios without providing any narrative discussion. Moreover, the company states that a "complete analysis is available upon request". If you want to impress the investor, it might be in your best interest to use the narrative ratio analysis approach. To do this, simply calculate each ratio for the three year forecasted period and then briefly discuss the variable(s) causing the change in the ratio value.

This concludes our discussion on how the projected ratio analysis should appear in your Financial Plan. Remember, it is imperative to understand the theory behind the ratio analysis before attempting to forecast your own. To learn more about how to read or determine the meaning behind ratios, please refer to the section entitled " Ratio Analysis ". This section also provides  other ratio formulas which you may decide to include in your analysis.

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What Is Financial Analysis?

• How It Works

Corporate Financial Analysis

Investment financial analysis, types of financial analysis, horizontal vs. vertical analysis, the bottom line.

• Corporate Finance
• Financial statements: Balance, income, cash flow, and equity

Financial Analysis: Definition, Importance, Types, and Examples

Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment.

Key Takeaways

• If conducted internally, financial analysis can help fund managers make future business decisions or review historical trends for past successes.
• If conducted externally, financial analysis can help investors choose the best possible investment opportunities.
• Fundamental analysis and technical analysis are the two main types of financial analysis.
• Fundamental analysis uses ratios and financial statement data to determine the intrinsic value of a security.
• Technical analysis assumes a security's value is already determined by its price, and it focuses instead on trends in value over time.

Investopedia / Nez Riaz

Understanding Financial Analysis

Financial analysis is used to evaluate economic trends, set financial policy, build long-term plans for business activity, and identify projects or companies for investment.

This is done through the synthesis of financial numbers and data. A financial analyst will thoroughly examine a company's financial statements—the income statement, balance sheet, and cash flow statement. Financial analysis can be conducted in both corporate finance and investment finance settings.

One of the most common ways to analyze financial data is to calculate ratios from the data in the financial statements to compare against those of other companies or against the company's own historical performance.

For example, return on assets (ROA) is a common ratio used to determine how efficient a company is at using its assets and as a measure of profitability. This ratio could be calculated for several companies in the same industry and compared to one another as part of a larger analysis.

There is no single best financial analytic ratio or calculation. Most often, analysts use a combination of data to arrive at their conclusions.

In corporate finance, the analysis is conducted internally by the accounting department and shared with management in order to improve business decision-making. This type of internal analysis may include ratios such as net present value (NPV) and internal rate of return (IRR) to find projects worth executing.

Many companies extend credit to their customers. As a result, the cash receipt from sales may be delayed for a period of time. For companies with large receivable balances, it is useful to track days sales outstanding (DSO), which helps the company identify the length of time it takes to turn a credit sale into cash. The average collection period is an important aspect of a company's overall cash conversion cycle .

A key area of corporate financial analysis involves extrapolating a company's past performance, such as net earnings or profit margin, into an estimate of the company's future performance. This type of historical trend analysis is beneficial to identify seasonal trends.

For example, retailers may see a drastic upswing in sales in the few months leading up to Christmas. This allows the business to forecast budgets and make decisions, such as necessary minimum inventory levels, based on past trends.

In investment finance, an analyst external to the company conducts an analysis for investment purposes. Analysts can either conduct a top-down or bottom-up investment approach.

A top-down approach first looks for macroeconomic opportunities, such as high-performing sectors, and then drills down to find the best companies within that sector. From this point, they further analyze the stocks of specific companies to choose potentially successful ones as investments by looking last at a particular company's fundamentals.

A bottom-up approach, on the other hand, looks at a specific company and conducts a similar ratio analysis to the ones used in corporate financial analysis, looking at past performance and expected future performance as investment indicators.

Bottom-up investing forces investors to consider microeconomic factors first and foremost. These factors include a company's overall financial health, analysis of financial statements, the products and services offered, supply and demand, and other individual indicators of corporate performance over time.

Financial analysis is only useful as a comparative tool. Calculating a single instance of data is usually worthless; comparing that data against prior periods, other general ledger accounts, or competitor financial information yields useful information.

There are two types of financial analysis as it relates to equity investments: fundamental analysis and technical analysis.

Fundamental Analysis

Fundamental analysis uses ratios gathered from data within the financial statements, such as a company's earnings per share (EPS), in order to determine the business's value.

Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued.

Technical Analysis

Technical analysis uses statistical trends gathered from trading activity, such as moving averages (MA).

Essentially, technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to predict market movements by looking for patterns and trends in stock prices and volumes rather than analyzing a security’s fundamental attributes.

When reviewing a company's financial statements, two common types of financial analysis are horizontal analysis and vertical analysis . Both use the same set of data, though each analytical approach is different.

Horizontal analysis entails selecting several years of comparable financial data. One year is selected as the baseline, often the oldest. Then, each account for each subsequent year is compared to this baseline, creating a percentage that easily identifies which accounts are growing (hopefully revenue) and which accounts are shrinking (hopefully expenses).

Vertical analysis entails choosing a specific line item benchmark, and then seeing how every other component on a financial statement compares to that benchmark.

Most often, net sales are used as the benchmark. A company would then compare the cost of goods sold, gross profit, operating profit, or net income as a percentage of this benchmark. Companies can then track how the percentage changes over time.

Examples of Financial Analysis

In Q1 2024, Amazon.com reported a net income of $10.4 billion. This was a substantial increase from one year ago when the company reported a net income of $3.2 billion in Q1 2023.

Analysts can use the information above to perform corporate financial analysis. For example, consider Amazon's operating profit margins below, which can be calculated by dividing operating income by net sales.

• 2024: $15,307 / $143,313 = 10.7%
• 2023: $4,774 / $127,358 = 3.7%

From Q1 2023 to Q1 2024, the company experienced an increase in operating margin, allowing for financial analysis to reveal that the company earned more operating income for every dollar of sales.

Why Is Financial Analysis Useful?

The financial analysis aims to analyze whether an entity is stable, liquid, solvent, or profitable enough to warrant a monetary investment. It is used to evaluate economic trends, set financial policies, build long-term plans for business activity, and identify projects or companies for investment.

How Is Financial Analysis Done?

Financial analysis can be conducted in both corporate finance and investment finance settings. A financial analyst will thoroughly examine a company's financial statements—the income statement, balance sheet, and cash flow statement.

One of the most common ways to analyze financial data is to calculate ratios from the data in the financial statements to compare against those of other companies or against the company's own historical performance. A key area of corporate financial analysis involves extrapolating a company's past performance, such as net earnings or profit margin, into an estimate of the company's future performance.

What Techniques Are Used in Conducting Financial Analysis?

Analysts can use vertical analysis to compare each component of a financial statement as a percentage of a baseline (such as each component as a percentage of total sales). Alternatively, analysts can perform horizontal analysis by comparing one baseline year's financial results to other years.

Many financial analysis techniques involve analyzing growth rates including regression analysis, year-over-year growth, top-down analysis, such as market share percentage, or bottom-up analysis, such as revenue driver analysis .

Lastly, financial analysis often entails the use of financial metrics and ratios. These techniques include quotients relating to the liquidity, solvency, profitability, or efficiency (turnover of resources) of a company.

What Is Fundamental Analysis?

Fundamental analysis uses ratios gathered from data within the financial statements, such as a company's earnings per share (EPS), in order to determine the business's value. Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued.

What Is Technical Analysis?

Technical analysis uses statistical trends gathered from market activity, such as moving averages (MA). Essentially, technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.

Financial analysis is a cornerstone of making smarter, more strategic decisions based on the underlying financial data of a company.

Whether corporate, investment, or technical analysis, analysts use data to explore trends, understand growth, seek areas of risk, and support decision-making. Financial analysis may include investigating financial statement changes, calculating financial ratios, or exploring operating variances.

U.S. Securities and Exchange Commission. " Amazon.com Form 10-Q for the Quarter Ended March, 31, 2024 ," Page 4.

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How to Write the Financial Section of a Business Plan

An outline of your company's growth strategy is essential to a business plan, but it just isn't complete without the numbers to back it up. here's some advice on how to include things like a sales forecast, expense budget, and cash-flow statement..

A business plan is all conceptual until you start filling in the numbers and terms. The sections about your marketing plan and strategy are interesting to read, but they don't mean a thing if you can't justify your business with good figures on the bottom line. You do this in a distinct section of your business plan for financial forecasts and statements. The financial section of a business plan is one of the most essential components of the plan, as you will need it if you have any hope of winning over investors or obtaining a bank loan. Even if you don't need financing, you should compile a financial forecast in order to simply be successful in steering your business. "This is what will tell you whether the business will be viable or whether you are wasting your time and/or money," says Linda Pinson, author of Automate Your Business Plan for Windows  (Out of Your Mind 2008) and Anatomy of a Business Plan (Out of Your Mind 2008), who runs a publishing and software business Out of Your Mind and Into the Marketplace . "In many instances, it will tell you that you should not be going into this business." The following will cover what the financial section of a business plan is, what it should include, and how you should use it to not only win financing but to better manage your business.

Dig Deeper: Generating an Accurate Sales Forecast

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How to Write the Financial Section of a Business Plan: The Purpose of the Financial Section Let's start by explaining what the financial section of a business plan is not. Realize that the financial section is not the same as accounting. Many people get confused about this because the financial projections that you include--profit and loss, balance sheet, and cash flow--look similar to accounting statements your business generates. But accounting looks back in time, starting today and taking a historical view. Business planning or forecasting is a forward-looking view, starting today and going into the future. "You don't do financials in a business plan the same way you calculate the details in your accounting reports," says Tim Berry, president and founder of Palo Alto Software, who blogs at Bplans.com and is writing a book, The Plan-As-You-Go Business Plan. "It's not tax reporting. It's an elaborate educated guess." What this means, says Berry, is that you summarize and aggregate more than you might with accounting, which deals more in detail. "You don't have to imagine all future asset purchases with hypothetical dates and hypothetical depreciation schedules to estimate future depreciation," he says. "You can just guess based on past results. And you don't spend a lot of time on minute details in a financial forecast that depends on an educated guess for sales." The purpose of the financial section of a business plan is two-fold. You're going to need it if you are seeking investment from venture capitalists, angel investors, or even smart family members. They are going to want to see numbers that say your business will grow--and quickly--and that there is an exit strategy for them on the horizon, during which they can make a profit. Any bank or lender will also ask to see these numbers as well to make sure you can repay your loan. But the most important reason to compile this financial forecast is for your own benefit, so you understand how you project your business will do. "This is an ongoing, living document. It should be a guide to running your business," Pinson says. "And at any particular time you feel you need funding or financing, then you are prepared to go with your documents." If there is a rule of thumb when filling in the numbers in the financial section of your business plan, it's this: Be realistic. "There is a tremendous problem with the hockey-stick forecast" that projects growth as steady until it shoots up like the end of a hockey stick, Berry says. "They really aren't credible." Berry, who acts as an angel investor with the Willamette Angel Conference, says that while a startling growth trajectory is something that would-be investors would love to see, it's most often not a believable growth forecast. "Everyone wants to get involved in the next Google or Twitter, but every plan seems to have this hockey stick forecast," he says. "Sales are going along flat, but six months from now there is a huge turn and everything gets amazing, assuming they get the investors' money."  The way you come up a credible financial section for your business plan is to demonstrate that it's realistic. One way, Berry says, is to break the figures into components, by sales channel or target market segment, and provide realistic estimates for sales and revenue. "It's not exactly data, because you're still guessing the future. But if you break the guess into component guesses and look at each one individually, it somehow feels better," Berry says. "Nobody wins by overly optimistic or overly pessimistic forecasts."

Dig Deeper: What Angel Investors Look For

How to Write the Financial Section of a Business Plan: The Components of a Financial Section

A financial forecast isn't necessarily compiled in sequence. And you most likely won't present it in the final document in the same sequence you compile the figures and documents. Berry says that it's typical to start in one place and jump back and forth. For example, what you see in the cash-flow plan might mean going back to change estimates for sales and expenses.  Still, he says that it's easier to explain in sequence, as long as you understand that you don't start at step one and go to step six without looking back--a lot--in between.

• Start with a sales forecast. Set up a spreadsheet projecting your sales over the course of three years. Set up different sections for different lines of sales and columns for every month for the first year and either on a monthly or quarterly basis for the second and third years. "Ideally you want to project in spreadsheet blocks that include one block for unit sales, one block for pricing, a third block that multiplies units times price to calculate sales, a fourth block that has unit costs, and a fifth that multiplies units times unit cost to calculate cost of sales (also called COGS or direct costs)," Berry says. "Why do you want cost of sales in a sales forecast? Because you want to calculate gross margin. Gross margin is sales less cost of sales, and it's a useful number for comparing with different standard industry ratios." If it's a new product or a new line of business, you have to make an educated guess. The best way to do that, Berry says, is to look at past results.
• Create an expenses budget. You're going to need to understand how much it's going to cost you to actually make the sales you have forecast. Berry likes to differentiate between fixed costs (i.e., rent and payroll) and variable costs (i.e., most advertising and promotional expenses), because it's a good thing for a business to know. "Lower fixed costs mean less risk, which might be theoretical in business schools but are very concrete when you have rent and payroll checks to sign," Berry says. "Most of your variable costs are in those direct costs that belong in your sales forecast, but there are also some variable expenses, like ads and rebates and such." Once again, this is a forecast, not accounting, and you're going to have to estimate things like interest and taxes. Berry recommends you go with simple math. He says multiply estimated profits times your best-guess tax percentage rate to estimate taxes. And then multiply your estimated debts balance times an estimated interest rate to estimate interest.
• Develop a cash-flow statement. This is the statement that shows physical dollars moving in and out of the business. "Cash flow is king," Pinson says. You base this partly on your sales forecasts, balance sheet items, and other assumptions. If you are operating an existing business, you should have historical documents, such as profit and loss statements and balance sheets from years past to base these forecasts on. If you are starting a new business and do not have these historical financial statements, you start by projecting a cash-flow statement broken down into 12 months. Pinson says that it's important to understand when compiling this cash-flow projection that you need to choose a realistic ratio for how many of your invoices will be paid in cash, 30 days, 60 days, 90 days and so on. You don't want to be surprised that you only collect 80 percent of your invoices in the first 30 days when you are counting on 100 percent to pay your expenses, she says. Some business planning software programs will have these formulas built in to help you make these projections.
• Income projections. This is your pro forma profit and loss statement, detailing forecasts for your business for the coming three years. Use the numbers that you put in your sales forecast, expense projections, and cash flow statement. "Sales, lest cost of sales, is gross margin," Berry says. "Gross margin, less expenses, interest, and taxes, is net profit."
• Deal with assets and liabilities. You also need a projected balance sheet. You have to deal with assets and liabilities that aren't in the profits and loss statement and project the net worth of your business at the end of the fiscal year. Some of those are obvious and affect you at only the beginning, like startup assets. A lot are not obvious. "Interest is in the profit and loss, but repayment of principle isn't," Berry says. "Taking out a loan, giving out a loan, and inventory show up only in assets--until you pay for them." So the way to compile this is to start with assets, and estimate what you'll have on hand, month by month for cash, accounts receivable (money owed to you), inventory if you have it, and substantial assets like land, buildings, and equipment. Then figure out what you have as liabilities--meaning debts. That's money you owe because you haven't paid bills (which is called accounts payable) and the debts you have because of outstanding loans.
• Breakeven analysis. The breakeven point, Pinson says, is when your business's expenses match your sales or service volume. The three-year income projection will enable you to undertake this analysis. "If your business is viable, at a certain period of time your overall revenue will exceed your overall expenses, including interest." This is an important analysis for potential investors, who want to know that they are investing in a fast-growing business with an exit strategy.

Dig Deeper: How to Price Business Services

How to Write the Financial Section of a Business Plan: How to Use the Financial Section One of the biggest mistakes business people make is to look at their business plan, and particularly the financial section, only once a year. "I like to quote former President Dwight D. Eisenhower," says Berry. "'The plan is useless, but planning is essential.' What people do wrong is focus on the plan, and once the plan is done, it's forgotten. It's really a shame, because they could have used it as a tool for managing the company." In fact, Berry recommends that business executives sit down with the business plan once a month and fill in the actual numbers in the profit and loss statement and compare those numbers with projections. And then use those comparisons to revise projections in the future. Pinson also recommends that you undertake a financial statement analysis to develop a study of relationships and compare items in your financial statements, compare financial statements over time, and even compare your statements to those of other businesses. Part of this is a ratio analysis. She recommends you do some homework and find out some of the prevailing ratios used in your industry for liquidity analysis, profitability analysis, and debt and compare those standard ratios with your own. "This is all for your benefit," she says. "That's what financial statements are for. You should be utilizing your financial statements to measure your business against what you did in prior years or to measure your business against another business like yours."  If you are using your business plan to attract investment or get a loan, you may also include a business financial history as part of the financial section. This is a summary of your business from its start to the present. Sometimes a bank might have a section like this on a loan application. If you are seeking a loan, you may need to add supplementary documents to the financial section, such as the owner's financial statements, listing assets and liabilities. All of the various calculations you need to assemble the financial section of a business plan are a good reason to look for business planning software, so you can have this on your computer and make sure you get this right. Software programs also let you use some of your projections in the financial section to create pie charts or bar graphs that you can use elsewhere in your business plan to highlight your financials, your sales history, or your projected income over three years. "It's a pretty well-known fact that if you are going to seek equity investment from venture capitalists or angel investors," Pinson says, "they do like visuals."

Dig Deeper: How to Protect Your Margins in a Downturn

Related Links: Making It All Add Up: The Financial Section of a Business Plan One of the major benefits of creating a business plan is that it forces entrepreneurs to confront their company's finances squarely. Persuasive Projections You can avoid some of the most common mistakes by following this list of dos and don'ts. Making Your Financials Add Up No business plan is complete until it contains a set of financial projections that are not only inspiring but also logical and defensible. How many years should my financial projections cover for a new business? Some guidelines on what to include. Recommended Resources: Bplans.com More than 100 free sample business plans, plus articles, tips, and tools for developing your plan. Planning, Startups, Stories: Basic Business Numbers An online video in author Tim Berry's blog, outlining what you really need to know about basic business numbers. Out of Your Mind and Into the Marketplace Linda Pinson's business selling books and software for business planning. Palo Alto Software Business-planning tools and information from the maker of the Business Plan Pro software. U.S. Small Business Administration Government-sponsored website aiding small and midsize businesses. Financial Statement Section of a Business Plan for Start-Ups A guide to writing the financial section of a business plan developed by SCORE of northeastern Massachusetts.

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• Financial Ratio Analysis Excel Template

There are 4 main categories of financial ratios and KPIs used by financial practitioners, each addressing a specific question:

Question 1: “Is the business profitable?” -> Profitability ratios , calculated from the P&L (e.g. Gross margin, EBITDA margin, EBIT margin)

Question 2: “Is the business liquid in the short term?” -> Liquitidity ratios , calculated from the Balance Sheet (e.g. current ratio, liquid ratio, cash ratio)

Question 3: “Is the business financially stable in the long term?” – > Stability ratios , calculated from the Balance Sheet (e.g. debt-to-equity ratio, gearing, debt cover ratio)

Question 4: “Is profitability high enough compared to what we have invested?” – > Capital Efficiency ratios (e.g. ROE taking an ‘equity’ perspective; ROIC taking an ‘entity’ point of view).

In additional, practitioners often undertake a Cost Structure Analysis , as well as a Working Capital Analysis (e.g. receivables days, inventory days, payable days).

This analysis is not hard when you understand the meaning of these ratios, and how to calculate them. To help you get started, Investaura Management Consultants is pleased to provide you with this Financial Ratio Analysis template. Enjoy!

• Financial Results template with full financial statements