You might have heard of the word ratio during your Math classes before, maybe from the news, or from professionals. But, what really is a financial ratio?
In the world of business, financial statements play a vital role in the assessment of the condition and performance of businesses. This gives the internal and external users the detailed report that they need in order to come up with a sound decision. But sometimes, too many details and numbers can be hard to comprehend and look chaotic. So through financial statements, the financial ratios are created. It presents the financial data of the company through ratios or percentages. This is simplified financial data that gives easier access to its users, especially those who do not have a background in accounting. These ratios are later on analyzed quantitatively to assess and help the company run better.
What are the Financial Ratios?
Financial Ratios, by nature, provide insight into a company’s health and enable them to make better financial decisions. There are a bunch of financial ratios to be found online but listed below is the rundown of the basics that every founder should know. These ratios are the foundations of goal-setting and measuring a company’s performance, and so it is important to understand what and how they work.
- Profitability Ratio
Of course, when establishing a business our main goal is to earn profits. In this ratio, we raise the question, “How profitable is your business?”. This ratio assesses if the company is able to generate income with the resources that it has; if they are either over or under utilizing its total assets and investments.
Profitability ratio has three basic types namely the (a) Gross Profit Margin, (b) Net Profit Margin, and ( c) Return on Assets. Let’s identify them all in detail.
Gross Profit Margin – wherein the overall profit earned by the company is compared to the overall sales that they generated, in order to see how much profit they were able to earn after paying the cost of goods sold. This can be computed just by dividing the gross profit over net sales.
Net Profit Margin – wherein the overall profit of the business after the deduction of all costs and expenses is computed by dividing the net profit by total sales. This compares the total profits of a business to its total expenses.
Return on Assets – wherein the ability of the company to produce a profit from its overall investments in assets is assessed. This also determines how much time a business consumes to recover the total investment in assets. It is computed by dividing the net profit by total assets.
These three are keys to understanding the way you earn profits and the factors that comes from it. Apart from those, we should also take note of other reasons why we should not overlook the importance of profitability ratio. It can increase your chances of getting a business loan approval, and it can also attract potential investors to your business. Given the competition in businesses today, it is only right to keep up and increase your level of efficiency to stay profitable in the long run.
- Liquidity Ratio
During business operations, debts and other expenses arise. And this ratio assesses if the company will or will not be having cash problems by looking if it can fund its operations and pay its debts and expenses.
The liquidity ratio has two basic types, namely the (a) Current ratio and (b) Quick ratio. These two serve the same purposes but differ in the assets that are used to pay off short-term liabilities.
Current ratio – wherein the company is assessed if it can pay off short-term liabilities with current assets. Some examples of these are cash, accounts receivable, inventory, and prepaid expenses. The current ratio is computed by dividing the total current assets over total liabilities, wherein the ideal current ratio is 2. This ratio only means that for every 1 current liability, there should be 2 current assets wherein the remaining 1 is for the current operation.
Quick ratio – wherein the company is assessed if it can pay off short-term liabilities with quick assets, or those that are readily convertible into cash. For example, cash equivalents like treasury bills and cheques, and marketable securities. The quick ratio is computed by dividing the total current assets less the total cost of inventory over total current liabilities, wherein the ideal current ratio is 1.5. This means that for every 1 current liability, there should be 1.5 current assets, wherein the difference of 0.50 is for the current operation.
A good liquidity ratio reflects a company’s good health and is most likely to face financial hardships. It does not only track your company’s financial health, but it can also secure your business a loan or funding, given that you are able to pay your debts.
- Leverage Ratio
Companies rely on a mixture of debts and equity to finance their operations. They generate an amount of capital in the form of loans (debts), wherein this ratio assesses if the company is able to meet its financial obligations while keeping the operations of the business.
The leverage ratio has two basic types, namely the (a) Debt ratio and (b) Equity ratio.
Debt ratio – wherein it measures the amount of the company’s assets that are provided from debt. It is the share of the creditors over the company’s assets. It is computed by dividing the total liabilities over total assets. An ideal debt ratio should be kept below 50%.
Equity Ratio – wherein it measures the amount of the company’s asset generated from issued equity shares instead of debt. It is the share of stockholders over the company’s assets. It is computed by dividing the total equities over total assets. An ideal equity ratio should be kept at more than 50%.
Leverage ratios show project risks that the lenders or investors will be dwelling on. Through leverage ratios, they can determine if the amount of risk is worth it or not. To be more efficient in this, it is only right to understand the concept of leverage as it is a critical part of your company’s capital structure and obtaining finances.
Knowing and understanding the basics of financial ratios is one big step in maintaining your company’s good health and competitive standing. But, to be greater ahead, it would be better to engage your business with trusted partners!
Search no further, as THRIVE Global CFO is here and can be reached easily by simply booking a free strategy call. We can talk more in detail and you can get to know more about the services we offer and the benefits you will eventually have as we thrive together to greatness!