Financial ratios can be helpful tools in understanding your company’s financial health. They are a benchmark by which you can compare your business to industry standards and analyze changes over time.
In fact, benchmarking and comparing to your competition is so important to business success that I provide all my business clients with an annual report on the benchmarks and results for their particular industry or profession. Without this it can be like traveling back roads without a map.
One warning though. If you begin comparing your results and calculating your ratios with incorrect accounting information from your business you just may wind up making the wrong decisions. All of the financial review and performance measurement we can discuss is of no use if your business's basic financial statements are not perfectly in order. Not sure how your stack up? Give us or your CPA a call and ask.
By using financial ratios you can determine just where you stand in relation to liquidity, debt levels and profitability. Following are the more commonly used ratios to see how you're doing.
The current ratio measures a company’s ability to meet its short-term obligations.
Current ratio = current assets ÷ current liabilities
Current assets and liabilities are short-term assets and liabilities – it is expected that current assets will be turned into cash and current liabilities paid within one year.
For example, a company with current assets of $1,500,000 and current liabilities of $700,000 has a current ratio of 2.14. A current ratio of 2.0 is often seen as acceptable but this depends on the industry. In general, the more liquid a company’s current assets the smaller the current ratio can be without causing concern.
The quick ratio (also called acid test) is similar to the current ratio but it doesn’t include inventory.
Quick ratio = (current assets – inventory) ÷ current liabilities
A quick ratio of 1 is generally recommended but the ideal does vary between industries. When inventory cannot be easily converted into cash the quick ratio provides a more accurate measure of overall liquidity. When a firm’s inventory is liquid the current ratio is better for measuring liquidity.
The debt ratio measures the proportion of a firm’s total assets that are financed by its creditors. The higher the debt ratio, the more credit is being used by the firm.
Debt ratio = total liabilities ÷ total assets
For example, a company with $2,500,000 in total liabilities and $4,200,000 in total assets will have a debt ratio of 0.60, or 60 per cent. This debt ratio shows that 60 per cent of this company’s assets are financed with debt. Companies with high debt ratios are ‘highly leveraged’.
Times interest earned ratio
This ratio measures a company’s ability to make contractual interest payments.
Times interest earned = earnings before interest and taxes ÷ interest
The higher the times interest earned ratio, the greater the firm’s ability to meet interest payment obligations.
For example, a company with earnings before interest and taxes of $1.9 million and annual interest obligations of $450,000 will have a times interest earned ratio of 4.2. A times interest earned ratio between 3.0 and 5.0 is considered to be acceptable in most cases.
Gross profit margin
The gross profit margin measures the percentage of profit remaining after the cost of goods sold – but not other expenses – have been paid. This ratio gives an indication on whether the average mark up on goods and services is sufficient. The larger the gross margin, the more able a firm is to cover expenses and make a profit.
Gross profit margin = (sales – cost of goods sold) ÷ sales = gross profits ÷ sales
For example, a company with $6.5 million in sales and $4.7 million in cost of goods sold will have a gross margin of 28 per cent.
Net profit margin
The net profit margin measures the percentage of sales dollars remaining after the all expenses, including the cost of goods sold and taxes, have been paid. It is considered a key performance indicator of a firm’s success.
Net profit margin = net profits after taxes ÷ sales
If a company has sales of $2.1 million and a net profit after taxes of $260,000, its net profit margin is 12 per cent.
What can be considered an acceptable net profit margin varies between industries. A net profit margin of 1 per cent is not unusual for a supermarket while a software company might have a net profit margin of 25 per cent.
Financial ratios can be an effective way to analyze your business performance over time and against industry averages. There are many other benchmark ratios depending on the type of business you have (inventory turnover, asset usage, days to collect, etc.). If you'd like some help determining your financial ratios and how your business compares against standard benchmarks drop me a line.
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