Accounting or financial ratios give business owners a more in-depth look at the financial health of their business. By primarily using numbers found on the company’s financial statements for financial statement analysis, ratios can also be used to analyze trends and offer potential investors better insight into the financial status of a company they’re interested in.
There’s no shortage of accounting and financial ratios, with hundreds available to choose from. Many are also easy to calculate, needing only a current balance sheet or income statement in order to calculate the ratio.
But beyond calculating these ratios, it’s also important for business owners to understand exactly what the results mean, and how those results can be used to better manage their business.
Ratio analysis categories
There are hundreds of ratios available to calculate, with five basic ratio categories available. These categories include the following.
1. Profitability ratios
Profitability ratios are perhaps used more frequently than other ratios for a variety of reasons. Profitability ratios provide insight into how well a company is able to generate profits and control expenses. Profit margin, gross margin, and return on equity ratios are all profitability ratios.
2. Liquidity ratios
A liquidity ratio is used to measure the amount of cash a company has available to cover their short-term debts as they become due. Liquidity ratios can help identify problem areas and ensure that you don’t come up short when payment is due. Both the current ratio and the quick ratio are examples of a liquidity ratio.
3. Activity ratios
Activity ratios, also called efficiency ratios are used to calculate how efficiently a company uses both assets and inventory to generate sales. For example, activity ratios look at average total assets to calculate the asset turnover ratio. Other activity ratios include inventory turnover and receivables turnover ratio.
4. Leverage ratios
Also known as debt or solvency ratios, leverage ratios are used to determine if a company is able to repay long-term debt and interest on that debt by looking at assets, equity, and earnings. Leverage ratios include debt to equity ratio and equity multiplier ratio.
5. Market ratios
Market ratios look at stock performance and are used to better predict earnings and future performance. Market ratios are commonly used by investors to measure both current stock cost as well as its current value as an investment. Market ratios include a loan-to-value ratio and the price to earnings ratio.
“Profitability ratios provide insight into how well a company is able to generate profits and control expenses. These ratios are key to the financial health of any business and accurate data is of key importance.”
Accounting ratios for your business
Though some business owners shy away from calculating accounting ratios, the majority of them are easy to calculate and provide valuable insight into business operations. With hundreds of ratios to choose from, the following are some of the best ratios for you to calculate for your business.
1. Gross profit margin ratio
Calculating gross profit margin ratio for your business is both smart and simple. All you need in order to calculate this ratio is a current income statement, where you can obtain both cost of goods sold and total revenue. To calculate your gross profit margin ratio, you would subtract cost of goods sold from total revenue to get net revenue and then divide net revenue by total revenue.
For example, if your revenue is $5 million and your cost of goods sold is $2.9 million, your total net revenue is $2.1 million. You would then divide your net revenue by your gross revenue to obtain your gross profit margin ratio. The formula looks like this:
($5,000,000 – $2,900,000) / $5,000,000 = 0.42 or 42%
The result shows that you have a gross profit margin of 42%, earning $0.42 for each dollar you receive in sales. Gross profit margin is a good marker for overall financial health. For more in-depth results, some businesses also calculate net profit margin, which takes into account all company expenses, not just cost of goods sold.
Gross profit margin varies by industry, but generally speaking, a 5% gross profit margin is considered low, 10% gross profit margin is considered average, while a 20% margin is good.
2. Return on assets
Return on assets takes a quick look at how efficiently your company turns investments into profits. This ratio is important for internal management as well as for outside investors that may have an interest in your company.
To calculate your return on assets, divide your net income by total assets. For example, if your net income is $1 million and your total assets are $2.5 million, your total return on assets would be 40%.
$1,000,000 / $2,500,000 = 0.40 or 40%
A asset return of 5% is considered good, while a 20% return or higher is considered excellent, since a higher return suggests that your company is earning more income with less invested.
3. Return on investment ratio
The return on investment (ROI) ratio gives you some insight into how much of your original investment has become profit. Useful for startups, ROI should be calculated anytime you make a significant investment into your business.
Calculating your ROI is simple. You just need your total earnings for the period in question as well as the amount of your initial investment. For example, if you invested $250,000 into your business and your earnings for that same period of time total $275,000, you would calculate your ROI as follows.
($275,000 – $250,000) / $250,000 = 10%
Most investors consider a good ROI around 7%, though experts says that a business needs to have a minimum ROI of 10% in order to fund growth properly.
4. Quick ratio
The quick ratio, also known as the acid-test ratio, is one of the easiest ratios to calculate is used to evaluate your company’s ability to meet its immediate financial obligations. All you need is a current balance sheet to calculate a quick ratio.
For example, let’s say your current assets equal $12.5 million, with current liabilities of $3 million and inventory of $5 million. Your first step would be to subtract your inventory total from your assets, and then divide the total by your current liabilities to obtain the quick ratio.
($12,500,000 – $5,000,000) / $3,000,000 = 2.5
This result means that your company currently has $2.50 in assets for each dollar in liabilities. A minimum ratio of one-to-one is recommended for companies in order to pay liabilities, but a higher ratio indicates you have extra cash. But be careful; too high of a quick ratio may mean that you’re not using your assets properly.
5. Current ratio
The current ratio, also known as the working capital ratio, is similar to the quick ratio in many ways. A liquidity ratio that is a simple calculation, the current ratio is used to determine your ability to pay off debt. The main difference is the inclusion of current assets or inventory totals in your calculation. If you do not carry inventory in your business, the quick ratio and the current ratio are identical.
Using the same totals as the quick ratio above, you would calculate your current ratio like this:
$12,500,000 / $3,000,000 = 4.16
This result, which includes your inventory total, indicates that your company has $4.16 in assets for every dollar of liabilities. And like the quick ratio, you’ll want at least a one-to-one result in order for your business to remain healthy.
Other similar liquidity ratios include:
- The operating cash flow ratio, which compares active cash flow from operations to the current liabilities of a company.
- The cash ratio, which compares cash and cash equivalents to the current liabilities of a company.
6. Inventory turnover ratio
If you sell products, you should calculate your inventory turnover ratio annually. Calculated in three separate steps, the inventory turnover ratio provides you with the number of times inventory turned over or sold during a specific time frame. A higher turnover rate indicates a more efficient operation, while a lower inventory turnover ratio can point to overstocking or lack of product movement.
To get started calculating your inventory turnover ratio, you’ll need your cost of goods sold from your income statement, your beginning and ending inventory for the time frame, and your average inventory.
For example, if your cost of goods sold is $30,million, your beginning inventory $8.7 million and your ending inventory $8.6 million, you would calculate the inventory turnover ratio as follows:
$30,000,000 / $8,650,250 = 3.47
This means that on average, you sell your inventory 3.4 times over a year’s period. Businesses should aim to have a turnover ratio between 5 and 10. Anything below 5 could indicate sluggish sales or excess inventory.
7. Accounts receivable turnover ratio
If you offer credit terms to your customers, the receivables turnover ratio can be incredibly helpful. The receivables turnover ratio lets you know how effectively you’re managing your credit customers, and even more important, how quickly you collect on any outstanding balances.
To calculate your receivables turnover ratio, first obtain your net sales for credit customers for the period in question. We’ll say that your net credit sales total $150 million
Be sure to eliminate any cash sales that were made. You’ll then need to obtain your beginning and your ending accounts receivable balances. For instance, if your beginning accounts receivable balance is $15 million and your ending balance is $18 million, your average accounts receivable balance is $16.5 million. That is the number you’ll use to complete the accounts receivable ratio.
$150,000,000 / $16,500,000 = 9.1
The higher the number, the more quickly you’re collecting on your accounts receivable balances.
To see the average number of days it takes to collect your accounts receivable, you can do this calculation:
365 / 9.1 = 40
That means that it’s taking you an average of 40 days to collect your outstanding balances, which can indicate a problem if your credit terms are Net 30. A higher number indicates that your customers are paying quickly, but too high of a number suggests that you’re only offering credit terms to select customers.
8. Accounts payable turnover ratio
Also known as the creditor’s turnover ratio is used to measure the average number of times creditors are paid during a specific period of time. The accounts payable turnover ratio is calculated by dividing your total net credit purchases by your average accounts payable balance. Like the accounts receivable turnover ratio, you’ll need to calculate your average payables balance by taking the beginning and ending totals for the period you’re calculating.
For example, let’s say your net purchases for the period totaled $9.5 million. Your beginning accounts payable balance totaled $1.5 million with an ending balance of $1.7 million, making your average balance $1.6 million.
$9,500,000 / $1,600,000 = 5.94
This number means that accounts payable turned over around 6 times over the time period. If you wish to calculate turnover in days, you can do the following calculation.
365 / 5.94 = 61 days
That means that it takes approximately 61 days to pay vendors. Like the accounts receivable turnover ratio, a higher number is better, with a higher number indicating that debts are paid quickly.
For more timely, efficient payment of accounts payable, you may want to consider a procure-to-pay software option such as PLANERGY, which manages the entire process from initial purchase request to invoice payment.
9. Debt-to-equity ratio
A debt-to-equity ratio, also known as a debt-to-asset ratio, looks at your total debt in comparison to your total assets to calculate your current financial leverage. Used to determine how much of your business assets are financed by third parties such as loans and how much is financed from owner equity, the debt-to-equity ratio is particularly useful for investors to determine whether shareholder equity is able to cover all outstanding liabilities in case of possible financial issues.
Calculating a debt-to-equity ratio is fairly simple and uses numbers from your balance sheet:
Debt-to-equity ratio = Total liabilities / Shareholder’s equity
A business with $125 million in liabilities and $180 million in shareholder’s equity would have a debt-to-equity ratio of 0.69.
$125,000,000 / $180,000,000 = 0.69
The result above indicates that the company has $0.69 in debt for every $1 of equity. For most industries, a debt-to-equity ratio of less than one is considered safe, while anything over 2.0 means your company is highly leveraged.
The key to ratios is analyzing the results
While ratios can provide key insights into your business health, they serve no real purpose if you don’t understand what the results mean. Once you calculate a ratio, be sure to use those results to better understand your business or make any necessary changes in your business. If you want more information about ratios or what the results mean, be sure to consult your accounting professional, who can provide you with further insight.
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