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How To Use Financial Ratios To Better Understand Your Business

January 28, 2021 |

Numbers tell a story. We already know that: we’re all experienced data-driven storytellers here.

But raw data, even after it’s been summarized in your reports, does not a full story make. Like the words of a novel, you’ll get more out of the values you report on when you start putting them together in new and meaningful ways. 

That’s where financial ratios come in.

Terminology
Financial Ratios

Ratios use the numbers in your balance sheet, income statement and cash flow statement and turn them into rich and powerful information. Information your internal team, investors and creditors can use to better understand your business performance—from liquidity and growth to profitability and rates of return.

By tracking changes over time, your ratios enable you to see how performance shifts from one period to the next, identify any trends that could be in the works and set goals and track progress towards them. They allow you and your investors to compare your business to those of your competitors, to see how you’re faring compared to market norms. And they’re pivotal in finding new lenders, setting stock prices and demonstrating the health of your organization as a whole.

So what are the ratios you should be paying attention to—and what plot twists will they add to the story your reporting tells? Let’s take a look.

The Five Types of Financial Ratios

Financial ratios enable you to perform quantitative analysis to understand your organization better. There’s an entire list of financial ratios you can draw from to better tell the story of your business—all of them falling under one of five main categories:

Each category incorporates a range of different ratios designed to help finance teams, like yours, get to the information needed, and for investors and analysts to better understand the health of your business. Together, these ratios can begin to offer a fuller picture of your company’s performance.

Examples, Calculations and Use Cases

The most popular financial ratios aren’t necessarily complicated to compute—in fact, what are often deceptively simple calculations can offer a wealth of meaningful information. Just look at these examples:

Financial Ratio

Example

Calculation

Use Cases

Profitability Ratios

Profit Margin

Gross Profit Margin = Gross Income / Revenue 

Operating Profit Margin = Operating Income / Revenue 

Net Profit Margin = Net Income / Revenue 

By demonstrating what percentage of sales has turned into profits, your Profit Margin showcases the degree to which a business activity makes money. The numbers you plug in will vary depending on the type of profit margin being measured (i.e., Gross Profit Margin, Operating Profit Margin, Net Profit Margin).

Return On Assets (ROA)

ROA = Net Income / Average Total Assets

ROA measures your company’s efficiency in generating earnings from assets by showcasing how much profit your company can gain from those assets.

Return On Equity (ROE)

ROE = Annual Net Income / Shareholders’ Equity

ROE demonstrates how well your organization is handling shareholder contributions. It measures the profitability of your organization as it relates to stockholders’ equity.

Liquidity Ratios

Current Ratio

Current Ratio = Current Assets / Current Liabilities

By looking at current assets in relation to current liabilities, your Current Ratio helps investors better understand your organization’s ability to pay off short-term debt obligations.

Quick Ratio

Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities 

By examining how easily your organization can use near-cash assets to pay down its current liabilities, your Quick Ratio measures your organization’s ability to meet its short-term debt obligations using its most liquid assets.

Days Sales Outstanding (DSO)

DSO = (Accounts Receivable / Net Credit Sales) x Number of Days

Your DSO provides valuable information on your cash conversion cycle by measuring the average number of days it takes for your business to collect payment from a sale. 

Efficiency Ratios

Asset Turnover Ratio

Asset Turnover Ratio = Net Sales / Average Total Assets

The Asset Turnover Ratio demonstrates how efficient your company is at using assets to generate revenue. It examines the value of your company’s sales or revenue in relation to the value of its assets.

Inventory Turnover Ratio

Inventory Turnover = Cost of Goods Sold / Average Inventory

By measuring how often a company has replaced inventory during a specified period, the Inventory Turnover Ratio helps you better determine pricing and know when to purchase new inventory.

Receivables Turnover Ratio

Receivables Turnover = Net Credit Sales / Average Accounts Receivable

By measuring your business’s ability to collect the money you owe, your Receivables Turnover Ratio helps investors and analysts understand how quickly your short-term debt is collected and paid.

Leverage Ratios

Debt Ratio

Debt Ratio = Total Debt / Total Assets

Your Debt Ratio measures the ratio of total debt to total assets, which determines the extent of your business’s leverage or the percentage of assets financed by debt.

Debt-to-Equity (D/E) Ratio

D/E = Total Liabilities / Total Shareholders’ Equity

By calculating how well shareholder equity can cover outstanding debt, your D/E Ratio helps determine how much of your business is financed through debt—and how prepared you are for a crisis.

Interest Coverage Ratio

Interest Coverage = Earnings Before Interest and Taxes (EBIT)  / Interest Expense

Your Interest Coverage Ratio lets creditors, investors and analysts know whether your company is a good risk for future lending by measuring how easily your organization can pay interest on its outstanding debt.

Debt-Service Coverage Ratio (DSCR)

DSCR = Net Operating Income / Debt Service

By looking at the cash flow your organization has available to pay your existing debt obligations, your DSCR lets investors know whether you have the income available to pay off your debts. 

Market Value Ratios

Book Value Per Share (BVPS)  Ratio 

BVPS = (Shareholders’ Equity - Preferred Stock) / Average Shares Outstanding

Your BVPS Ratio helps investors evaluate your business’s stock price by measuring the ratio between your shareholders’ equity and outstanding shares. 

Dividend Yield Ratio

Dividend Yield = Annual Dividends Per Share / Current Share Price

By calculating, in the form of a percentage, how much your business pays out annually in dividends in relation to its stock price, the Dividend Yield Ratio enables investors to calculate how much they’ll earn from dividends.

Earnings Per Share (EPS) Ratio

Earnings Per Share = (Net Income - Preferred Dividends) / Average Shares Outstanding

By looking at your company’s profit in relation to outstanding shares, your EPS Ratio lets you and your investors know how much money your company earns from each share of its stock, helping to create an estimate of your overall organizational value.

What Else You Need To Know About Financial Ratios

If you’re a finance professional tasked with reporting, you’re probably using financial ratios in some capacity already—and it’s exactly because they are so widely used that they’re so useful. 

Financial ratios provide a common language. By trending your ratios over time, you and your investors can compare your company’s performance from one period to another, and against market norms and competitors. And by using the reported values already available in your balance sheet, income statement and cash flow statement, ratios also provide a relatively quick way to analyze your financial health.

The richest stories come not from using a single financial ratio, though, but rather by applying a mix of ratios and using them alongside the other information available to you. That might include insights from your KPI dashboards or the information you gather from non-financial metrics across sales, marketing, operations and the rest of your organization. Either way, in doing so, you’ll reveal truths about your company’s performance—as well as the potential value your business might have for investors, creditors and lenders. 

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