Your Guide to Financial Ratio Analysisindustriuscfo.com /top-5-financial-ratios/

Key Financial Ratios Help Manage Your Business

Your attention is usually focused on a key area within your company. Maybe that’s in marketing, sales ortechnology. Handling the financials may not be your forte. But, it’s important to be able to analyze yourbusiness using financial ratios.

Financial ratios are used as indicators that allow you to zero in on areas of your business that may needattention, such as liquidity, profitability, operational efficiency, and solvency. Financial ratios are also usefultools in forecasting and financial analysis. They allow you to set specific goals and track your business’sprogress toward these goals.

It’s important to choose financial ratios that apply to your business. There are hundreds of financial ratiosout there and while some of them apply to all businesses – some of the financial ratios are industryspecific.

Here are the top five most powerful and widely known financial ratios you should use in order to make yourbusiness succeed:

1. Net Profit Margin

This ratio is the most important measurement. With this ratio, you can understand how each dollar earnedby your company is translated into profits.

How to calculate Net Profit Margin:

Net Profit / Net Sales

It indicates how efficient your company is at its cost control. For example, a higher Net Profit Marginmeans the business converts its revenue into actual profit more effectively.

You can use this ratio to compare yourself to your industry peers, as well.

2. Current Ratio

This ratio is a performance measurement of a company’s liquidity. The measurement determines if yourbusiness has enough resources to pay its debts over the next year. It includes your company’s cashamount and inventory.

How to calculate the Current Ratio:

Current Assets / Current Liabilities

Financial lenders who need to decide whether to give the business a short-term loan use this ratio. But, itcan also be used to view a snapshot of the efficiency of the company’s operating cycle or how well it canturn its product into cash.

3. Debt-to-Equity Ratio (D/E)

The Debt-to-Equity Ratio, also known as financial leverage, determines the relative proportion of abusiness’s equity and debt used to finance its assets. It’s a very important ratio as it’s used as a standardfor determining a business’s financial performance and whether it’s financially healthy.

How to calculate the D/E Ratio:

Total Liabilities / Shareholders Equity

The D/E ratio also shows the company’s ability torepay debts. Lenders prefer low D/E ratios. So, if theratio is increasing, this means that your business isnot being financed on its own, but instead by creditors– which could be a bad sign to financial lendinginstitutions.

4. Quick Ratio

The Quick Ratio, sometimes referred to as the QuickAssets Ratio or “acid test,” provides you a short-termview of the company’s cash situation or liquidity inrelation to its short-term debts so you can determinewhether a business can meet its financial obligations if issues arise.

How to calculate the Quick Ratio:

(Current Assets – Inventories)/ Current Liabilities

You are looking for a higher quick ratio here.

5. Return on Equity (ROE) Ratio

The ROE ratio, or Return on Net Worth (RONW), is one of the most important profitability metrics. It showsyou how much profit a business earned compared to the total amount of shareholder equity found on thebalance sheet.

In other words, it measures how profitable a business is for the investor and how profitably it utilizesequity. Note: this ratio is expressed as a percentage.

How to calculate ROE:

Net Income/Shareholder’s Equity

Financial ratios can be complex, but just by simply converting all of this raw data, which can be found onfinancial statements, into information you need helps make your business a success! And, luckily for you –there is a simpler way to compute most of these complex financial ratios by using IndustriusCFO’sproducts that include ratio calculators. Use our financial analysis suite and start building a better, moreprofitable business.

Pinpoint that one difference maker that has been eluding you. Know what portions of your business needattention and adjustments to help you grow and be more profitable. Generate a quick snapshot of yourbusiness’s health and a game plan to begin making improvements today. IndustriusCFO’s ratio calculatorscan compute these standard, common ratios:

LIQUIDITY RATIOS:

Quick Ratio

Current Ratio

Current Liabilities to Net Worth – this is the measure of the extent to which the enterprise is usingcreditor funds vs. their own investment to finance the business.

How to Calculate Current Liabilities to Net Worth:

Current Liabilities/Liabilities + Equity

You don’t want to see a ratio of .5 or higher because that would indicate inadequate owner investment oran extended accounts payable period.

Current Liabilities to Inventory – this ratio offers an indication of the ability of your firm’s inventorysales to generate cash needed to meet the short-term obligation of creditors. Look for the result of alow ratio, which means that your company will be able to meet short-term obligations. A high ratiomay be cause for concern since it may signal a potential cash shortage.

How to Calculate Current Liabilities to Inventory:

Current Liabilities x 100/Available Inventory

Total Liabilities to Net Worth – this ratio reveals the relation between the total debts and the owners’equity of a company. You want to see a higher ratio here, which indicates less protection forbusiness’ creditors.

How to Calculate Total Liabilities to Net Worth:

Total Liabilities/Liabilities + Equity

Fixed Assets to Net Worth – The Center for Business Planning says this is the measure of theextent of an enterprise’s investment in non-liquid and often over valued fixed assets.You don’t wantto see the result of .75 or higher because this indicates possible over-investment and causes alarge annual depreciation charge that will be subtracted from the income statement.

How to Calculate Fixed Assets to Net Worth:

Fixed assets to Net Worth=Net fixed assets/Net Worth

Interest Coverage – this ratio is used to determine how easily your business can pay interest onoutstanding debt.

How to Calculate Interest Coverage:

EBIT/Interest Expense

Cash Conversion Cycle (measured in days) – this ratio measures how fast your business canconvert cash on hand into even more cash on hand.

How to Calculate Cash Conversion Cycle:

Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

PROFITABILITY RATIOS:

Return on Sales – this ratio is also known as a firm’s operating profit margin and is widely used to

evaluate a business’s operational efficiency. This ratio provides insight into how much profit is beingproduced per dollar of sales. The ratio is helpful to management.

How to calculate this profitability ratio:

Net Income (Before Interest and Tax)/Sales

Return on Assets – Also known as Return on Investment, this ratio is an indicator of how muchprofitable a company is relative to its total assets. It gives you an idea as to how well your companyis using its assets to produce earnings.

How to calculate Return on Assets:

Net Income/Total Assets

It’s also important to note that when performing this calculation, some investors add interest expense backinto net income because they want to use operating returns before cost of borrowing.

Sales per Employee or Revenue per Employee – this ratio will help you examine your business’ssales in relation to its number of employees. It’s most useful when you compare your results to yourindustry peers.

How to calculate Sales per Employee:

Revenue/# of employees

You want to see the highest revenue possible per employee possible because this means there’s higherproductivity.

Profit per Employee – Mark Staniszewski, IndustriusCFO account manager says, “This is ameasure of the profits your firm is generating for each employee working for you. The managementof labor resources is important to the success of your business and you should carefully compareboth sales and profits per employee for your firm with similar firms in your industry.”

How to calculate Profit per Employee:

Net Profit/Number of Employees

Asset Investment to Sales – this ratio measures a company’s efficiency in managing its assets inrelation to the revenue created. The higher this ratio, the smaller the investment required to producesales revenue, thus, higher the profitability of the company.

The formula to calculate Asset Investment to Sales:

Sales Revenue/Total Assets

Gross Margin – this ratio is also known as the gross profit margin or gross profit percentage. Youshould be continuously monitoring your company’s gross margin ratio to make sure it will result in agross profit that will be enough to cover its selling and administrative costs.

How to compute Gross Margin:

Gross Profit Dollars/Net Sales Dollars

Since gross margin ratios vary between industries, you should compare your company’s gross margin

ratio to your industry peers.

IndustriusCFO also computes asset efficiency ratios that are measured in days including Collection Period,Payment Deferral Period, Inventory Turnover, and Age of Inventory. These asset efficiency ratios are notmeasured in days: Assets to Sales, Sales to Working Capital, and Accounts Payable to Sales.

Other ratios we compute include Book Value to Total Assets ( Valuation Ratio), Debt to Equity Ratio(Leverage Ratio), Growth Rate (Growth Ratio), and Sustainable Growth Rate (Growth Ratio).

Financial Ratios Related to Financial Statements

A traditional way to convey relationships between oneaspect of the Income Statement to another, is by wayof percentage. Given the nature of how thesepercentages are calculated, they can certainly bequalified as ratios and provide meaningful informationfor comparing your business’s performance againstpast operating periods, or comparison to industrypeers.

To illustrate how these ratios can provide impactfulinformation for your business, let’s assume your business has $1,000,000 in Net Sales. Thebusiness’s Overhead is $100,000. You’ll want to display this as a percentage, which allows you to easilycompare your results to your business’s past performance and against industry peers.

Considering the above example, the calculation would be $100,000/$1,000,000. Overhead is “10%” of NetSales. Say, last year, your business’s overhead was 15% of Net Sales, or Industry Peer trends showOverhead at 12% of Net Sales. As you can see, it’s far easier to compare your results as a percentagerather than less-than-comparable USD ($) figures.

Income Statement analyses include such financial ratios when displayed in percentage, by showing therelationship of each Income Statement account as a % of Net Sales:

Cost of Sales OR Cost of Goods Sold (Service company vs. Manufacturing)

Material Cost

Labor Cost

Overhead

Gross Profit Margin (already above)

Operating Expenses

Salaries/Wages

Rent

Bad Debt

Advertising/Marketing

Other Operating Expenses

EBITDA ( earnings before interest, tax, depreciation & amortization )

Depreciation & Amortization

EBIT (earnings before interest and taxes, otherwise known as “Operating Profit”)

Interest Expense

Other Expense

EBT

Income Taxes

Net Income

The accounts associated with the Assets side of the Balance Sheet are traditionally shown as a % of TotalAssets, and include:

Total Current Assets

Cash

Accounts Receivable

Inventory

Prepaid Expenses

Other Current Assets

Total Non-Current Assets

Fixed Assets

Intangible Assets

Long-Term Investments

Other Non-Current Assets

The accounts associated with the Liabilities & Net Worth side of the Balance Sheet are traditionally shownas a % of Total Liabilities and include the following:

Total Current Liabilities

Accounts Payable

Short-Term Notes Payable

Bank Loan Payable

Current Maturities of Long-Term Debt

Other Current Liabilities

Total Long-Term Liabilities

Long-Term Notes Payable

Other Non-Current Liabilities

Net Worth

IndustriusCFO’s Financial Ratio Analysis Expands on Traditional Ratios

Net Balance Position (NBP) , and NBP Ratio – traditional Liquidity ratios, like the Quick andCurrent Ratio tend to cluster aspects of the Balance Sheet and thus, some Liquidity and AssetEfficiency issues may remain hidden. For example, imagine two companies, one having $100K inCash, $400K in Accounts Receivable (AR), the other having $250K in Cash and $250K in AR.

If all else were equal between the two companies, the Quick and Current Ratios would view them as

performing equally, because they both have $500K in Current Assets. However, one company has farbetter efficiency in AR collection, with much more Cash on hand. This deeper assessment is madepossible, by a proprietary measure developed to tease apart aspects of the Balance Sheet and provide amore stringent measure of Cash Liquidity. If your NBP is zero or positive, your company is in a decentliquidity position.

How to calculate Net Balance Position:

Operating Capital Available – Operating Capital Required = NBP

Return on Asset Investment – this is a returns ratio that will allow you to calculate how efficientlyyour company is using their total asset base to generate sales. The reason that the return on assetsratio is also known as the return on investment ratio is because investment refers to a firm’sinvestment in its assets.

How to calculate Return on Asset Investment:

Return on Assets = Net Income (Net Profit)/Total Assets= __%

Understanding financial ratios is a key business skill for any entrepreneur or business owner. Tosummarize what we’ve discussed in this guide to financial ratio analysis, financial ratios illustrate thestrengths and weaknesses of your business. By analyzing these ratios over time, you have the ability tonotice any unusual fluctuations in financial performance across different operating periods, and whencompared to industry peers or competitors.