business plan ratio analysis

🎧 Real entrepreneurs. Real stories.

Subscribe to The Hurdle podcast today!

How to Use These Common Business Ratios

2 min. read

Updated October 27, 2023

What business ratios should you know and be using? Here’s a breakdown of common ratios, how they’re used, and in some cases how you’ll calculate them.

Main ratios

• Current. Measures company’s ability to meet financial obligations. Expressed as the number of times current assets exceed current liabilities. A high ratio indicates that a company can pay its creditors. A number less than one indicates potential cash flow problems.
• Quick. This ratio is very similar to the Acid Test (see below), and measures a company’s ability to meet its current obligations using its most liquid assets. It shows Total Current Assets excluding Inventory divided by Total Current Liabilities.
• Total Debt to Total Assets. Percentage of Total Assets financed with debt.
• Pre-Tax Return on Net Worth. Indicates shareholders’ earnings before taxes for each dollar invested. This ratio is not applicable if the subject company’s net worth for the period being analyzed has a negative value.
• Pre-Tax Return on Assets. Indicates profit as a percentage of Total Assets before taxes. Measures a company’s ability to manage and allocate resources.

Additional ratios

• Net Profit Margin. This ratio is calculated by dividing Sales into the Net Profit, expressed as a percentage.
• Return on Equity. This ratio is calculated by dividing Net Profit by Net Worth, expressed as a percentage.

Activity ratios

• Accounts Receivable Turnover. This ratio is calculated by dividing Sales on Credit by Accounts Receivable. This is a measure of how well your business collects its debts.
• Collection Days. This ratio is calculated by multiplying Accounts Receivable by 360, which is then divided by annual Sales on Credit. Generally, 30 days is exceptionally good, 60 days is bothersome, and 90 days or more is a real problem.
• Inventory Turnover. This ratio is calculated by dividing the Cost of Sales by the average Inventory balance.
• Accounts Payable Turnover. This ratio is a measure of how quickly the business pays its bills. It divides the total new Accounts Payable for the year by the average Accounts Payable balance.
• Payment Days. This ratio is calculated by multiplying average Accounts Payable by 360, which is then divided by new Accounts Payable.
• Total Asset Turnover. This ratio is calculated by dividing Sales by Total Assets.

Debt ratios

• Debt to Net Worth. This ratio is calculated by dividing Total Liabilities by total Net Worth.
• Current Liab. to Liab. This ratio is calculated by dividing Current Liabilities by Total Liabilities.

Liquidity ratios

• Net Working Capital. This ratio is calculated by subtracting Current Liabilities from Current Assets. This is another measure of cash position.
• Interest Coverage. This ratio is calculated by dividing Profits Before Interest and Taxes by total Interest Expense.
• Assets to Sales. This ratio is calculated by dividing Assets by Sales.
• Current Debt/Total Assets. This ratio is calculated by dividing Current Liabilities by Total Assets.
• Acid Test. This ratio is calculated by dividing Current Assets (excluding Inventory and Accounts Receivable) by Current Liabilities.
• Sales/Net Worth. This ratio is calculated by dividing Total Sales by Net Worth.
• Dividend Payout. This ratio is calculated by dividing Dividends by Net Profit.

In the real world, financial profile information involves some compromise. Very few organizations fit any one profile exactly. Variations, such as doing several types of business under one roof, are quite common. If you cannot find a classification that fits your business exactly, use the closest one and explain in your text how and why your business is different from the standard.

Brought to you by

Create a professional business plan

Using ai and step-by-step instructions.

Secure funding

Validate ideas

Build a strategy

Tim Berry is the founder and chairman of Palo Alto Software , a co-founder of Borland International, and a recognized expert in business planning. He has an MBA from Stanford and degrees with honors from the University of Oregon and the University of Notre Dame. Today, Tim dedicates most of his time to blogging, teaching and evangelizing for business planning.

Table of Contents

Related Articles

10 Min. Read

What Is a Balance Sheet? Definition, Formulas, and Example

7 Min. Read

7 Financial Terms Small Business Owners Need to Know

6 Min. Read

How to Forecast Sales for a Subscription Business

5 Min. Read

9 Common Mistakes with Business Financial Projections

The LivePlan Newsletter

Become a smarter, more strategic entrepreneur.

Your first monthly newsetter will be delivered soon..

Unsubscribe anytime. Privacy policy .

The quickest way to turn a business idea into a business plan

Fill-in-the-blanks and automatic financials make it easy.

No thanks, I prefer writing 40-page documents.

Discover the world’s #1 plan building software

Financial Reporting and Analysis Software

• Our products:
• Financial Analysis
• Reporting Tool
• US Industry Benchmarking
• Russian Entites Profiles

Ratio Analysis

Meaning and definition of Ratio Analysis

Ratio analysis is a tool brought into play by individuals to carry out an evaluative analysis of information in the financial statements of a company. These ratios are calculated from current year figures and then compared to past years, other companies, the industry, and also the company to assess the performance of the company. Besides, ratio analysis is used predominantly by proponents of financial analysis.

As stated by Investopedia, there are numerous ratios that can be estimated from the financial statements pertaining to a business company’s activity, performance, liquidity, and financing. Some of the most common ratios include the debt-equity ratio, price-earnings ratio, asset turnover , earnings per share , and working capital .

Benefits of Ratio Analysis

The ratio analysis forms an essential part of the financial analysis which is a vital part of business planning. The key benefits of ratio analysis include:

• Determines profitability

Ratio analysis assists managers to work out the production of the company by figuring the profitability ratios. Also, the management can evaluate their revenues to check if their productivity. Thus, probability ratios are helpful to the company in appraising its performance based on current earning.

• Helpful in evaluating solvency

By computing the solvency ratio, the companies are able to keep an eye on the correlation between the assets and the liabilities. If, in any case, the liabilities exceed the assets, the company is able to know its financial position. This is helpful in case they wish to set up a plan for loan repayment.

• Better financial analysis

Ratio analysis is also helpful to recluses, in addition to shareholders, debenture holders, and creditors. Besides, bankers are also able to know the profitability of the company to find out whether they are able to pay the dividend and interests under a specific period.

• Performance analysis

Ratio analysis is also helpful in analyzing the performance of a company. Through financial analysis, companies can review their performance in the past years. This is also helpful in identifying their weaknesses and improving on them.

• Forecasting

At present, many companies use ratio analysis to reveal the trends in production. This provides them an opportunity for estimation of future trends and thus the foundation for budget planning so as to determine the course of action for the growth and development of the business. 

• Financial Ratio
• Financial Statement Analysis
• Financial Ratio Analysis Software

Start free Ready Ratios financial analysis now!

No registration required! But once registered , additional features are available.

Most Wanted Financial Terms

• Most Important Financial Ratios
• Debt-to-Equity Ratio
• Current Ratio
• Interest Coverage Ratio (ICR)
• Financial Leverage
• Break-even Point

All terms →

• Terms of Use
• Privacy Policy

Login to Ready Ratios

If you have a Facebook or Twitter account, you can use it to log in to ReadyRatios:

Have you forgotten your password?

Are you a new user ?

Maintenance break

Monday (16.06.2024), 05:30 - 09:30 UTC

Our system will be temporarily unavailable due to new features implementation

What is a ratio analysis? Checking the financial health of your business

• Blog , Business

As a business owner or manager, you know that making informed decisions is essential to your company’s success. One powerful tool that can help you gain insight into your company’s financial health is a ratio analysis. By analyzing financial ratios, you can compare your company’s performance over time, identify its strengths and weaknesses, and make wiser decisions about your business strategy. In this blog post, we’ll take a closer look at what a ratio analysis is, how it works, and how you can use it to drive your business forward. Read on.

What is a ratio analysis? – table of contents:

What is a financial assessment of a company, what is a ratio analysis, types of financial ratios, how to conduct a ratio analysis.

A financial assessment of a company is about analyzing its performance, funds allocated to achieve certain goals, capital, turnover and losses. It’s usually carried out to detect any irregularities related to a company’s finances and make the necessary changes for further development . You can get the most relevant data from the balance sheet, income statement and cash flow statement.

A ratio analysis is one of the methods of analyzing a company’s financial performance . It lets you obtain data on liquidity, debt, profitability and many other areas relating to running a business. It involves comparing financial data from company reports, which can usually be found in online records.

There are several types of financial ratios used in a ratio analysis, for example, static, dynamic, relative, and absolute ratios. Static ratios use information from the income statement and the balance sheet, while dynamic ratios use the information from the cash flow statement. Absolute ratios relate to the financial resources of the company. On this basis, relative ratios are calculated, whose value is the quotient of absolute ratios.

Financial ratios can be grouped depending on the area of the company’s performance we want to analyze. For example, to evaluate a company’s profitability , we can look at ratios like return on investment or return on equity. To assess its solvency, we can examine liquidity ratios and debt ratios.

To get an idea of a company’s debts and its ability to pay them off, you should look at, for example:

• Debt to assets ratio that shows how much of a company’s assets are financed by debt. It is calculated by dividing the total amount of debt a company owes by the total value of its assets.
• Long-term debt to equity ratio that measures the amount of long-term debt a company has in relation to its equity.

To examine a company’s liquidity, you need to know the value of the current ratio that can be calculated by dividing a company’s current assets by its current liabilities.

Profitability

To check a company’s profitability, it is necessary to pay attention to sales results, profits and the way it uses its own capital. To this end, it’s useful to take a closer look at the following ratios:

• Return on sales (ROS) – it is calculated by dividing a company’s income by its net sales revenue.
• Return on equity (ROE) – it shows how much profit a company generates in relation to the amount of money invested by shareholders.
• Return on assets (ROA) – it measures how effectively a company uses its assets to generate profits.

Market efficiency

Market efficiency indicators allow you to assess how efficiently a company operates in its business environment. These are, for instance:

• Days sales outstanding (DSO) – it measures the average number of days it takes for a company to collect payment for its sales after the invoice has been issued.
• Days sales of inventory (DSI) – it shows the number of days it takes for a company to sell its inventory.
• Labor productivity index – it is calculated by dividing the company’s total sales revenue by the average number of employees over a given period of time.

Let’s explore how to use a ratio analysis to assess your company’s financial health.

Compare the actual state with the plan

Creating a comprehensive business plan and financial forecast before starting a company is crucial for tracking progress, assessing goal attainment, and identifying areas for improvement.

Review your company’s balance sheet

The balance sheet will give you an overview of your company’s financial position, including its assets and liabilities.

Take a look the income statement

The income statement can help you determine if your company’s expenses are exceeding its budget and whether sales goals are being achieved.

Analyze the cash flow statement

A cash flow statement is a financial statement that provides information about the cash inflows and outflows of a company during a specific period of time.

Calculate financial ratios

Use the collected data to calculate specific financial ratios. This will help you determine the current state of your business, identify any issues, and make necessary changes. Additionally, consider external factors and competition when conducting the analysis. In the example, we will show you how to calculate and interpret just a few of the indicators mentioned above.

Debt to assets ratio

Long-term debt to equity ratio

Equity can be calculated as the difference between a company’s assets and liabilities. The closer the value of a company’s long-term debt to equity ratio is to 1, the higher the proportion of debt to equity, which indicates higher indebtedness of the company.

Current ratio

A current ratio of 2 or higher indicates that a company may have excess liquidity. While having excess liquidity may seem favorable, it is not always the case since the available funds should be invested in profitable opportunities to generate higher returns. A ratio below 1.2 indicates a bad financial situation and there’s a risk of bankruptcy.

Return on sales (ROS)

A return on sales ratio of 0.25 means that for every dollar spent by the company, it generated 0.25 dollars (25 cents) in operating profit. If the return on sales ratio is lower, the company needs to achieve higher sales volume to maintain profitability.

Return on equity (ROE)

The higher the value of this ratio, the better it is for the company. Therefore, financial data from earlier periods should be used as a benchmark. In this case, there is no range that we should aim for. We may also receive negative values, which indicates incurred losses.

Return on assets (ROA)

A higher value of this ratio indicates a more favorable situation for the company. As previously mentioned, it’s essential to take into account previous financial statements to get a better perspective.

A ratio analysis is one of the ways to assess a company’s financial situation. To carry it out successfully, it is necessary to thoroughly prepare its financial statements and calculate certain values. What’s more, it’s essential to properly interpret the obtained data as the success of a company often depends on the decisions made based on this information. To get an objective assessment, it’s also helpful to keep in mind the general economic situation and other external factors that may affect the health of your company, and to compare the results with those of competitive entities.

If you like our content, join our busy bees community on Facebook, Twitter, LinkedIn, Instagram, YouTube, Pinterest, TikTok .

Author: Andy Nichols A problem solver with 5 different degrees and endless reserves of motivation. This makes him a perfect Business Owner & Manager. When searching for employees and partners, openness and curiosity of the world are qualities he values the most. View all posts

Free download

• Cooperation models
• Human Resources
• User Experience
• Project management

Recent posts

“We are all developers”. How can citizen developers help your company? | AI in business #74

1 big truth about software errors | #2 First steps in software testing

10 Best Content Creation Tools

10 best Google Chrome extensions for productivity

10 best platforms for selling ebooks – Create & sell digital products #13

10 best websites for small business owners

Set and accomplish your

Team goals with firmbee.

years of experience

users trusted our solutions 

team of experts

processed documents yearly

Start working with Firmbee to elevate your firm's efficiency. Manage teams and tasks with our project management module . Use CRM tools , regain finance control , and issue invoices with our free invoicing app .

• Polski ( Polish )
• Freelancer Management System
• Recruitment Software
• Free Invoicing App
• Project Management
• HR Management System

Useful links

• Help Center
• Terms And Conditions
• Privacy Policy
• Cookie Policy

Pobierz za darmo

Firmbee Invoice App

Unlimited invoicing

Ratio Analysis: How to Use Ratio Analysis to Assess the Financial Health of Your Business

1. what is ratio analysis and why is it important, 2. liquidity, solvency, profitability, and efficiency, 3. how to calculate and interpret common ratios, 4. examples of ratio analysis for different industries and businesses, 5. benefits and limitations of ratio analysis, 6. how to use ratio analysis to identify strengths and weaknesses of your business, 7. how to use ratio analysis to compare your business with competitors and benchmarks, 8. how to use ratio analysis to set goals and plan strategies for improvement, 9. key takeaways and recommendations for ratio analysis.

Ratio analysis is a technique that involves calculating and comparing various financial ratios from a company's financial statements. These ratios can help measure the profitability, liquidity, efficiency, solvency, and growth potential of a business . ratio analysis can also help compare the performance of a business with its competitors, industry standards, or historical trends. Ratio analysis is important because it can provide valuable insights into the financial health and performance of a business , which can help in making informed decisions , identifying strengths and weaknesses , and planning for the future.

Some of the benefits of ratio analysis are:

1. It can help evaluate the profitability of a business by analyzing how well it generates income from its assets, equity, and sales. Some of the common profitability ratios are return on assets (ROA) , return on equity (ROE) , gross profit margin , net profit margin , and operating margin . For example, a high ROA indicates that the business is efficient in using its assets to generate income , while a high gross profit margin indicates that the business has a low cost of goods sold relative to its sales.

2. It can help assess the liquidity of a business by measuring its ability to meet its short-term obligations and cash needs. Some of the common liquidity ratios are current ratio , quick ratio , and cash ratio . For example, a high current ratio indicates that the business has enough current assets to pay off its current liabilities , while a low cash ratio indicates that the business may face cash flow problems in the near future.

3. It can help measure the efficiency of a business by analyzing how well it manages its assets, inventory, and receivables. Some of the common efficiency ratios are asset turnover , inventory turnover , receivables turnover , and days sales outstanding (DSO) . For example, a high asset turnover indicates that the business is generating more sales per unit of asset, while a low DSO indicates that the business is collecting its receivables quickly.

4. It can help evaluate the solvency of a business by examining its ability to pay off its long-term debts and interest expenses. Some of the common solvency ratios are debt-to-equity ratio , debt-to-assets ratio , interest coverage ratio , and times interest earned ratio . For example, a low debt-to-equity ratio indicates that the business has a low level of debt relative to its equity, while a high interest coverage ratio indicates that the business has enough earnings to cover its interest payments.

5. It can help analyze the growth potential of a business by comparing its current performance with its past performance or its projected performance. Some of the common growth ratios are sales growth rate , earnings per share (EPS) growth rate , dividend payout ratio , and dividend yield . For example, a high sales growth rate indicates that the business is expanding its market share , while a high dividend payout ratio indicates that the business is distributing a large portion of its earnings to its shareholders.

Ratio analysis is a powerful tool that can help you understand the financial health and performance of your business. However, it is important to note that ratio analysis has some limitations, such as:

- It may not reflect the quality of the financial statements, which may contain errors, omissions, or manipulations.

- It may not account for the differences in accounting policies , methods, or standards among different businesses or industries.

- It may not capture the non-financial factors that may affect the business , such as customer satisfaction, employee morale, or environmental impact.

- It may not provide a complete picture of the business, as some ratios may contradict or complement each other.

Therefore, it is advisable to use ratio analysis with caution and in conjunction with other sources of information, such as qualitative analysis, industry analysis, and market analysis. By doing so, you can gain a comprehensive and balanced view of your business and make better decisions for its success .

Don't know how to estimate your startup value?

FasterCapital's experts work with you on valuing your startup through applying different valuation methods and planning for your coming rounds

Ratio analysis is a powerful tool for evaluating the financial performance and health of a business . By comparing different financial ratios, such as liquidity, solvency, profitability, and efficiency, one can gain insights into the strengths and weaknesses of a business, as well as its potential opportunities and threats. In this section, we will discuss the four types of ratios in detail and explain how they can be used to assess the financial health of your business.

1. Liquidity ratios measure the ability of a business to meet its short-term obligations and pay off its current liabilities. Liquidity ratios are important indicators of the financial stability and solvency of a business, as they show how well a business can manage its cash flow and working capital . Some common liquidity ratios are:

- current ratio : This ratio compares the current assets (such as cash, inventory, accounts receivable, etc.) to the current liabilities (such as accounts payable, short-term debt , etc.) of a business. A current ratio of 1 or more indicates that a business has enough current assets to cover its current liabilities. A current ratio of less than 1 indicates that a business may face liquidity problems and struggle to pay its bills on time . For example, if a business has $100,000 in current assets and $80,000 in current liabilities , its current ratio is $$\frac{100,000}{80,000} = 1.25$$, which means it has 1.25 times more current assets than current liabilities.

- quick ratio : This ratio is similar to the current ratio, but it excludes inventory from the current assets , as inventory may not be easily converted into cash . A quick ratio of 1 or more indicates that a business has enough liquid assets (such as cash, marketable securities, accounts receivable, etc.) to cover its current liabilities. A quick ratio of less than 1 indicates that a business may not have enough liquid assets to meet its short-term obligations . For example, if a business has $100,000 in current assets, $20,000 in inventory, and $80,000 in current liabilities, its quick ratio is $$\frac{100,000 - 20,000}{80,000} = 1$$, which means it has 1 times more liquid assets than current liabilities .

2. Solvency ratios measure the ability of a business to meet its long-term obligations and pay off its debt. Solvency ratios are important indicators of the financial leverage and risk of a business, as they show how much a business relies on debt to finance its operations and growth . Some common solvency ratios are:

- debt-to-equity ratio : This ratio compares the total debt (both short-term and long-term) to the total equity (the difference between assets and liabilities) of a business. A debt-to-equity ratio of less than 1 indicates that a business has more equity than debt , which means it has a lower financial risk and a higher financial strength. A debt-to-equity ratio of more than 1 indicates that a business has more debt than equity, which means it has a higher financial risk and a lower financial strength. For example, if a business has $200,000 in total debt and $100,000 in total equity, its debt-to-equity ratio is $$\frac{200,000}{100,000} = 2$$, which means it has 2 times more debt than equity .

- interest coverage ratio : This ratio compares the earnings before interest and taxes (EBIT) to the interest expense of a business. A interest coverage ratio of more than 1 indicates that a business has enough earnings to cover its interest payments, which means it has a lower default risk and a higher solvency. A interest coverage ratio of less than 1 indicates that a business may not have enough earnings to cover its interest payments, which means it has a higher default risk and a lower solvency. For example, if a business has $50,000 in EBIT and $10,000 in interest expense, its interest coverage ratio is $$\frac{50,000}{10,000} = 5$$, which means it has 5 times more earnings than interest expense.

3. Profitability ratios measure the ability of a business to generate profits from its revenues, assets, and equity. Profitability ratios are important indicators of the financial performance and efficiency of a business, as they show how well a business can utilize its resources and create value for its shareholders. Some common profitability ratios are:

- Gross profit margin : This ratio compares the gross profit (the difference between sales and cost of goods sold) to the sales of a business. A high gross profit margin indicates that a business has a low cost of goods sold and a high markup on its products or services, which means it has a high profitability and a high competitive advantage. A low gross profit margin indicates that a business has a high cost of goods sold and a low markup on its products or services, which means it has a low profitability and a low competitive advantage. For example, if a business has $100,000 in sales and $60,000 in cost of goods sold, its gross profit margin is $$\frac{100,000 - 60,000}{100,000} = 0.4$$, which means it has a 40% gross profit margin.

- Net profit margin : This ratio compares the net profit (the difference between sales and all expenses) to the sales of a business. A high net profit margin indicates that a business has a low operating and financing expenses and a high net income, which means it has a high profitability and a high efficiency. A low net profit margin indicates that a business has a high operating and financing expenses and a low net income, which means it has a low profitability and a low efficiency. For example, if a business has $100,000 in sales and $20,000 in net profit, its net profit margin is $$\frac{20,000}{100,000} = 0.2$$, which means it has a 20% net profit margin.

4. Efficiency ratios measure the ability of a business to manage its assets and liabilities effectively and generate sales. Efficiency ratios are important indicators of the financial productivity and quality of a business, as they show how well a business can turn its resources into revenues and profits. Some common efficiency ratios are:

- asset turnover ratio : This ratio compares the sales to the total assets of a business. A high asset turnover ratio indicates that a business has a high sales volume and a low asset base, which means it has a high efficiency and a high asset utilization. A low asset turnover ratio indicates that a business has a low sales volume and a high asset base, which means it has a low efficiency and a low asset utilization. For example, if a business has $100,000 in sales and $50,000 in total assets, its asset turnover ratio is $$\frac{100,000}{50,000} = 2$$, which means it has 2 times more sales than assets .

- inventory turnover ratio : This ratio compares the cost of goods sold to the average inventory of a business. A high inventory turnover ratio indicates that a business has a high sales volume and a low inventory level, which means it has a high efficiency and a high inventory management. A low inventory turnover ratio indicates that a business has a low sales volume and a high inventory level, which means it has a low efficiency and a low inventory management. For example, if a business has $60,000 in cost of goods sold and $10,000 in average inventory, its inventory turnover ratio is $$\frac{60,000}{10,000} = 6$$, which means it has 6 times more cost of goods sold than inventory.

One of the most important aspects of ratio analysis is to understand how to calculate and interpret common ratios. Ratios are numerical comparisons of two or more financial items that can reveal the strengths and weaknesses of a business. Ratios can be used to measure profitability, liquidity, solvency, efficiency, and valuation of a business. Different ratios can provide insights from different perspectives, such as the owners, the creditors, the managers, and the investors. In this section, we will discuss how to calculate and interpret some of the most common ratios used in ratio analysis . We will also provide examples to illustrate how ratios can be used to evaluate the financial health of a business.

Some of the common ratios that are used in ratio analysis are:

1. profitability ratios : These ratios measure how well a business generates income from its operations. They indicate the ability of a business to earn profits and create value for its shareholders. Some of the profitability ratios are:

- Gross profit margin : This ratio measures the percentage of revenue that is left after deducting the cost of goods sold . It shows how efficiently a business manages its production costs and pricing strategy. The formula for gross profit margin is:

$$\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Revenue}} \times 100\%$$

For example, if a business has a revenue of $500,000 and a cost of goods sold of $300,000, its gross profit margin is:

$$\text{Gross profit margin} = \frac{500,000 - 300,000}{500,000} \times 100\% = 40\%$$

A higher gross profit margin indicates a higher profitability and a lower production cost. A lower gross profit margin indicates a lower profitability and a higher production cost.

- Net profit margin : This ratio measures the percentage of revenue that is left after deducting all the expenses, including taxes and interest. It shows how effectively a business manages its overall costs and income. The formula for net profit margin is:

$$\text{Net profit margin} = \frac{\text{Net profit}}{\text{Revenue}} \times 100\%$$

For example, if a business has a revenue of $500,000 and a net profit of $50,000, its net profit margin is:

$$\text{Net profit margin} = \frac{50,000}{500,000} \times 100\% = 10\%$$

A higher net profit margin indicates a higher profitability and a lower expense ratio . A lower net profit margin indicates a lower profitability and a higher expense ratio.

- Return on assets (ROA) : This ratio measures how well a business uses its assets to generate income. It shows the efficiency of a business in managing its resources. The formula for ROA is:

$$\text{ROA} = \frac{\text{Net profit}}{\text{Total assets}} \times 100\%$$

For example, if a business has a net profit of $50,000 and a total assets of $250,000, its ROA is:

$$\text{ROA} = \frac{50,000}{250,000} \times 100\% = 20\%$$

A higher ROA indicates a higher profitability and a better asset utilization. A lower ROA indicates a lower profitability and a worse asset utilization.

- Return on equity (ROE) : This ratio measures how well a business generates income for its shareholders. It shows the return on the investment of the owners. The formula for ROE is:

$$\text{ROE} = \frac{\text{Net profit}}{\text{Shareholders' equity}} \times 100\%$$

For example, if a business has a net profit of $50,000 and a shareholders' equity of $200,000, its ROE is:

$$\text{ROE} = \frac{50,000}{200,000} \times 100\% = 25\%$$

A higher ROE indicates a higher profitability and a higher return for the shareholders. A lower ROE indicates a lower profitability and a lower return for the shareholders.

2. Liquidity ratios : These ratios measure how well a business can meet its short-term obligations with its current assets. They indicate the ability of a business to pay its debts and operate smoothly. Some of the liquidity ratios are:

- Current ratio : This ratio measures the proportion of current assets to current liabilities. It shows how easily a business can pay its current debts with its current resources. The formula for current ratio is:

$$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$$

For example, if a business has a current assets of $100,000 and a current liabilities of $50,000, its current ratio is:

$$\text{Current ratio} = \frac{100,000}{50,000} = 2$$

A higher current ratio indicates a higher liquidity and a lower risk of insolvency. A lower current ratio indicates a lower liquidity and a higher risk of insolvency.

- Quick ratio : This ratio measures the proportion of liquid current assets to current liabilities. It shows how quickly a business can pay its current debts with its most liquid resources. The formula for quick ratio is:

$$\text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$$

For example, if a business has a current assets of $100,000, an inventory of $20,000, and a current liabilities of $50,000, its quick ratio is:

$$\text{Quick ratio} = \frac{100,000 - 20,000}{50,000} = 1.6$$

A higher quick ratio indicates a higher liquidity and a lower risk of insolvency. A lower quick ratio indicates a lower liquidity and a higher risk of insolvency.

- Cash ratio : This ratio measures the proportion of cash and cash equivalents to current liabilities. It shows how readily a business can pay its current debts with its cash resources. The formula for cash ratio is:

$$\text{Cash ratio} = \frac{\text{Cash and cash equivalents}}{\text{Current liabilities}}$$

For example, if a business has a cash and cash equivalents of $40,000 and a current liabilities of $50,000, its cash ratio is:

$$\text{Cash ratio} = \frac{40,000}{50,000} = 0.8$$

A higher cash ratio indicates a higher liquidity and a lower risk of insolvency. A lower cash ratio indicates a lower liquidity and a higher risk of insolvency.

3. solvency ratios : These ratios measure how well a business can meet its long-term obligations with its total assets. They indicate the ability of a business to survive in the long run and maintain its operations. Some of the solvency ratios are:

- debt-to-asset ratio : This ratio measures the proportion of total debt to total assets . It shows how much of a business's assets are financed by debt. The formula for debt-to-asset ratio is:

$$\text{Debt-to-asset ratio} = \frac{\text{Total debt}}{\text{Total assets}}$$

For example, if a business has a total debt of $150,000 and a total assets of $250,000, its debt-to-asset ratio is:

$$\text{Debt-to-asset ratio} = \frac{150,000}{250,000} = 0.6$$

A higher debt-to-asset ratio indicates a higher leverage and a higher risk of default. A lower debt-to-asset ratio indicates a lower leverage and a lower risk of default.

- Debt-to-equity ratio : This ratio measures the proportion of total debt to shareholders' equity. It shows how much of a business's equity is financed by debt. The formula for debt-to-equity ratio is:

$$\text{Debt-to-equity ratio} = \frac{\text{Total debt}}{\text{Shareholders' equity}}$$

For example, if a business has a total debt of $150,000 and a shareholders' equity of $200,000, its debt-to-equity ratio is:

$$\text{Debt-to-equity ratio} = \frac{150,000}{200,000} = 0.75$$

A higher debt-to-equity ratio indicates a higher leverage and a higher risk of default. A lower debt-to-equity ratio indicates a lower leverage and a lower risk of default.

- Interest coverage ratio : This ratio measures how well a business can pay its interest expenses with its operating income. It shows the margin of safety of a business in meeting its interest obligations. The formula for interest coverage ratio is:

$$\text{Interest coverage ratio} = \frac{\text{Operating income}}{\text{Interest expense}}$$

For example, if a business has an operating income of $100,000 and an interest expense of $20,000, its interest coverage ratio is:

$$\text{Interest coverage ratio} = \frac{100,000}{20,000} = 5$$

A higher interest coverage ratio indicates a higher solvency and a lower risk of default. A lower interest coverage ratio indicates a lower solvency and a higher risk of default.

4. efficiency ratios : These ratios measure how well a business utilizes its assets and liabilities to generate revenue.

How to Calculate and Interpret Common Ratios - Ratio Analysis: How to Use Ratio Analysis to Assess the Financial Health of Your Business

Ratio analysis is a powerful tool that can help you evaluate the financial performance , profitability, liquidity, solvency, and efficiency of your business. However, different industries and businesses may have different standards and benchmarks for their ratios, depending on their nature, size, and market conditions. Therefore, it is important to understand how to use ratio analysis for different industries and businesses, and how to interpret the results in the right context. In this section, we will provide some examples of ratio analysis for different industries and businesses, and explain what they can tell you about their financial health.

Some examples of ratio analysis for different industries and businesses are:

1. Retail industry: The retail industry is characterized by high inventory turnover, low profit margins , and high competition. Therefore, some of the key ratios to look at for the retail industry are the inventory turnover ratio, the gross profit margin, and the net profit margin. The inventory turnover ratio measures how quickly a business sells its inventory, and is calculated by dividing the cost of goods sold by the average inventory. A high inventory turnover ratio indicates that the business is efficient in managing its inventory and has strong demand for its products. The gross profit margin measures how much of the sales revenue is left after deducting the cost of goods sold, and is calculated by dividing the gross profit by the sales revenue. A high gross profit margin indicates that the business has a competitive advantage in pricing its products or has low cost of goods sold. The net profit margin measures how much of the sales revenue is left after deducting all the expenses, and is calculated by dividing the net income by the sales revenue. A high net profit margin indicates that the business is profitable and has good control over its operating costs. For example, Walmart, one of the largest retailers in the world, had an inventory turnover ratio of 8.2, a gross profit margin of 24.2%, and a net profit margin of 3.1% in 2020, according to its annual report. These ratios show that Walmart is efficient in selling its inventory, has a moderate gross profit margin, and a low net profit margin, reflecting its low-price strategy and high operating expenses.

2. Manufacturing industry: The manufacturing industry is characterized by high fixed assets, high depreciation, and high operating leverage. Therefore, some of the key ratios to look at for the manufacturing industry are the fixed asset turnover ratio , the depreciation expense ratio, and the degree of operating leverage. The fixed asset turnover ratio measures how efficiently a business uses its fixed assets to generate sales, and is calculated by dividing the sales revenue by the net fixed assets. A high fixed asset turnover ratio indicates that the business is productive and has a high capacity utilization. The depreciation expense ratio measures how much of the sales revenue is used to cover the depreciation expense, and is calculated by dividing the depreciation expense by the sales revenue. A high depreciation expense ratio indicates that the business has a high capital intensity and a high wear and tear of its fixed assets. The degree of operating leverage measures how sensitive the net income is to changes in sales, and is calculated by dividing the percentage change in net income by the percentage change in sales. A high degree of operating leverage indicates that the business has high fixed costs and low variable costs, and therefore, a small change in sales can have a large impact on the net income. For example, Boeing, one of the largest manufacturers of aircrafts in the world, had a fixed asset turnover ratio of 0.4, a depreciation expense ratio of 3.6%, and a degree of operating leverage of 3.9 in 2019, according to its annual report. These ratios show that Boeing is inefficient in using its fixed assets, has a low depreciation expense ratio, and has a high degree of operating leverage, reflecting its high fixed costs and low variable costs.

3. Service industry: The service industry is characterized by low fixed assets, high labor costs, and high customer loyalty. Therefore, some of the key ratios to look at for the service industry are the asset turnover ratio , the labor expense ratio, and the customer retention rate . The asset turnover ratio measures how efficiently a business uses its total assets to generate sales, and is calculated by dividing the sales revenue by the total assets. A high asset turnover ratio indicates that the business is agile and has a low capital intensity. The labor expense ratio measures how much of the sales revenue is used to pay the employees, and is calculated by dividing the labor expense by the sales revenue. A high labor expense ratio indicates that the business has a high labor intensity and a high human capital. The customer retention rate measures how loyal the customers are to the business , and is calculated by dividing the number of repeat customers by the number of total customers. A high customer retention rate indicates that the business has a high customer satisfaction and a high brand equity. For example, Netflix, one of the largest providers of online streaming services in the world, had an asset turnover ratio of 0.7, a labor expense ratio of 12.4%, and a customer retention rate of 93% in 2020, according to its annual report. These ratios show that Netflix is efficient in using its assets, has a moderate labor expense ratio, and has a very high customer retention rate, reflecting its low capital intensity, high human capital, and high customer loyalty.

Examples of Ratio Analysis for Different Industries and Businesses - Ratio Analysis: How to Use Ratio Analysis to Assess the Financial Health of Your Business

Ratio analysis is a powerful tool that can help you evaluate the financial performance, profitability, liquidity, solvency, and efficiency of your business. By comparing different financial ratios, you can identify the strengths and weaknesses of your business, as well as the opportunities and threats in the market . However, ratio analysis also has some limitations that you should be aware of before relying on it too much. In this section, we will discuss the benefits and limitations of ratio analysis from different perspectives, such as investors, creditors, managers, and regulators.

1. It helps you to compare your business with other businesses in the same industry or sector, as well as with your own past performance. This way, you can benchmark your performance and identify the best practices and areas for improvement.

2. It helps you to communicate your financial results and position to various stakeholders, such as shareholders, lenders, customers, suppliers, and employees. By using ratios, you can simplify and summarize complex financial data and make it easier to understand and interpret.

3. It helps you to monitor and control your business operations and financial activities. By using ratios, you can track the changes in your financial situation and identify any potential problems or risks that may affect your business . For example, you can use ratios to measure your liquidity, which is your ability to meet your short-term obligations, or your solvency, which is your ability to meet your long-term obligations.

4. It helps you to plan and forecast your future financial performance and needs. By using ratios, you can project your future cash flows , revenues, expenses, profits, and growth. You can also use ratios to estimate your future financing requirements and sources, such as debt or equity.

Some of the limitations of ratio analysis are:

1. It may not reflect the true picture of your business, as it is based on historical data that may not be relevant or accurate. For example, your financial statements may not reflect the current market value of your assets or liabilities, or the impact of inflation or deflation on your revenues or costs.

2. It may not capture the qualitative aspects of your business , such as your customer satisfaction, employee morale, brand reputation, innovation, or social responsibility. These factors may have a significant impact on your long-term success and sustainability, but they are not easily measured or expressed by ratios.

3. It may not account for the differences in accounting policies, methods, standards, or practices among different businesses or countries. For example, different businesses may use different depreciation methods, inventory valuation methods , revenue recognition methods , or tax rates, which may affect their financial ratios and make them incomparable or misleading.

4. It may not consider the external factors that may influence your business, such as the economic, political, social, technological, environmental, or legal factors. These factors may affect the demand and supply of your products or services , the competition and regulation in your industry or sector, or the opportunities and threats in your market.

Ratio analysis is a powerful tool that can help you evaluate the financial performance and health of your business. By comparing different financial ratios, you can identify the strengths and weaknesses of your business, as well as the opportunities and threats in the market. Ratio analysis can also help you benchmark your business against your competitors and industry standards , and set realistic and achievable goals for improvement.

In this section, we will discuss how to use ratio analysis to identify the strengths and weaknesses of your business. We will cover the following topics:

1. The main types of financial ratios and what they measure

2. How to calculate and interpret the most common financial ratios

3. How to use ratio analysis to assess the liquidity, profitability, efficiency, solvency, and growth potential of your business

4. How to use ratio analysis to identify the internal and external factors affecting your business performance

5. How to use ratio analysis to compare your business with your competitors and industry norms

6. How to use ratio analysis to identify the areas of improvement and action plans for your business

Let's start with the first topic: the main types of financial ratios and what they measure.

## 1. The main types of financial ratios and what they measure

Financial ratios are numerical values that express the relationship between two or more financial items from your income statement, balance sheet, or cash flow statement . Financial ratios can be classified into four main categories:

- Liquidity ratios measure your ability to meet your short-term obligations and convert your assets into cash quickly and easily. Examples of liquidity ratios are the current ratio, the quick ratio, and the cash ratio.

- Profitability ratios measure your ability to generate income and profits from your operations and investments. Examples of profitability ratios are the gross profit margin , the net profit margin, the return on assets, and the return on equity.

- Efficiency ratios measure how well you use your resources and assets to generate sales and profits. Examples of efficiency ratios are the inventory turnover, the receivables turnover, the payables turnover, and the asset turnover.

- Solvency ratios measure your ability to meet your long-term obligations and maintain a healthy capital structure. Examples of solvency ratios are the debt-to-equity ratio, the debt-to-assets ratio, the interest coverage ratio, and the cash flow to debt ratio .

Each of these categories of ratios can provide valuable insights into different aspects of your business performance and health . However, it is important to note that financial ratios are not absolute indicators of success or failure. They should be used in conjunction with other financial and non-financial information , such as your business goals, strategies, plans, budgets, forecasts, market trends, customer feedback, etc. Moreover, financial ratios should be analyzed over time and compared with your previous results, your targets, your competitors, and your industry averages. This way, you can get a more comprehensive and accurate picture of your business situation and performance.

Ratio analysis is a powerful tool that can help you evaluate the financial performance and health of your business. However, ratio analysis is not only useful for internal decision making, but also for external comparison. By comparing your business ratios with those of your competitors and industry benchmarks , you can gain valuable insights into how your business is doing in relation to others, and identify areas of strength and weakness. In this section, we will discuss how to use ratio analysis to compare your business with competitors and benchmarks, and what to look out for when doing so. Here are some steps you can follow:

1. Identify the relevant ratios and sources of data. Depending on your business goals and industry , you may want to focus on different types of ratios, such as profitability, liquidity, efficiency, solvency, or growth. You can find the formulas and definitions of these ratios in our previous sections. To compare your ratios with others, you need to obtain the financial statements or reports of your competitors and industry benchmarks. You can use public sources such as company websites, annual reports, databases, or industry associations, or private sources such as market research firms , consultants, or trade journals. Make sure the data is reliable, accurate, and up-to-date.

2. Calculate and compare the ratios. Once you have the data, you can calculate the ratios for your business and the others using the same formulas and time periods. Then, you can compare the ratios and see how your business stands out. For example, if your gross profit margin is higher than your competitors, it means you have a competitive advantage in generating revenue from your sales . If your current ratio is lower than the industry average, it means you have less liquidity and may face difficulties in meeting your short-term obligations .

3. Analyze the results and identify the causes. Comparing the ratios is not enough, you also need to understand why the differences exist and what they imply for your business. You should consider the factors that may affect the ratios, such as the size, age, location, product mix, customer base, pricing strategy, cost structure, or accounting policies of your business and the others. You should also look at the trends and changes in the ratios over time, and see if they are consistent or fluctuating. For example, if your debt-to-equity ratio is increasing over time, it means you are relying more on debt financing and may face higher financial risk. If your inventory turnover ratio is decreasing over time, it means you are holding more inventory and may incur higher storage costs or obsolescence risks.

4. Take actions and monitor the outcomes. Based on your ratio analysis, you can identify the strengths and weaknesses of your business, and decide what actions you need to take to improve your performance or maintain your competitive edge . You can also set realistic and achievable goals and targets for your business, and measure your progress and results using the ratios. For example, if your return on assets ratio is lower than your competitors, you may want to increase your sales, reduce your expenses, or optimize your asset utilization . If your net profit margin ratio is higher than the industry average, you may want to maintain your pricing power , control your costs, or invest in growth opportunities. You should also monitor the outcomes of your actions and see if they have the desired effects on your ratios and performance.

Ratio analysis is a powerful tool that can help you evaluate the financial performance and health of your business. By comparing different financial ratios, you can identify the strengths and weaknesses of your business, set realistic goals , and plan effective strategies for improvement. In this section, we will discuss how to use ratio analysis to set goals and plan strategies for improvement for your business . We will cover the following topics:

1. How to choose the right ratios for your business goals

2. How to compare your ratios with industry benchmarks and competitors

3. How to use ratio analysis to identify areas of improvement and potential risks

4. How to use ratio analysis to plan and monitor your strategies for improvement

Let's start with the first topic: how to choose the right ratios for your business goals.

## How to choose the right ratios for your business goals

There are many different types of financial ratios that can measure various aspects of your business, such as profitability, liquidity, efficiency, leverage, and solvency. However, not all ratios are equally relevant or useful for your business goals. Depending on your industry, size, stage, and objectives, you may want to focus on different ratios that can help you assess your performance and progress.

For example, if your goal is to increase your profitability, you may want to look at ratios such as gross profit margin, net profit margin, return on assets, and return on equity. These ratios can tell you how much profit you are making from your sales, assets, and equity, and how efficiently you are using your resources.

If your goal is to improve your liquidity, you may want to look at ratios such as current ratio, quick ratio, and cash ratio. These ratios can tell you how well you can meet your short-term obligations with your current assets, and how much cash and cash equivalents you have on hand.

If your goal is to enhance your efficiency, you may want to look at ratios such as inventory turnover, accounts receivable turnover , and asset turnover. These ratios can tell you how quickly you are selling your inventory, collecting your receivables, and generating sales from your assets , and how effectively you are managing your working capital .

If your goal is to reduce your leverage, you may want to look at ratios such as debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio. These ratios can tell you how much debt you have compared to your equity and assets, and how easily you can pay your interest expenses with your earnings.

If your goal is to maintain your solvency, you may want to look at ratios such as cash flow to debt ratio , times interest earned ratio, and debt service coverage ratio. These ratios can tell you how much cash flow you have to cover your debt obligations, and how comfortably you can service your debt with your earnings.

The key is to choose the ratios that are most relevant and meaningful for your business goals, and to track them over time to see how they change and what they imply. You can also use a combination of ratios to get a more comprehensive picture of your business performance and health. For example, you can use profitability ratios and efficiency ratios together to see how your profit margins and turnover rates affect your overall profitability. Or you can use liquidity ratios and solvency ratios together to see how your short-term and long-term financial stability are related.

Ratio analysis is a powerful tool that can help you evaluate the financial performance, health, and efficiency of your business. By using various ratios, you can compare your business with industry standards , competitors, and your own historical data. You can also identify the strengths and weaknesses of your business, as well as the opportunities and threats in the market. However, ratio analysis is not a one-size-fits-all solution. You need to consider the context, purpose, and limitations of each ratio before drawing any conclusions. In this section, we will summarize the key takeaways and recommendations for ratio analysis from different perspectives: investors, creditors, managers, and customers.

- Investors are interested in the profitability, growth, and risk of your business. They use ratios such as return on equity (ROE), earnings per share (EPS), dividend payout ratio, price-to-earnings ratio (P/E), and beta to assess how well your business generates income, distributes dividends, and responds to market fluctuations. Some recommendations for investors are:

1. Look for businesses with high ROE and EPS, as they indicate efficient use of equity and strong earnings potential.

2. Compare the dividend payout ratio and P/E ratio with the industry average and the growth rate of the business. A high dividend payout ratio may indicate a mature and stable business, but it may also limit the reinvestment opportunities and future growth. A low P/E ratio may indicate an undervalued business, but it may also reflect low growth prospects or high risk.

3. Consider the beta of the business, which measures the sensitivity of its returns to the market movements . A high beta means that the business is more volatile and risky, but it may also offer higher returns in a bullish market. A low beta means that the business is more stable and less affected by the market, but it may also lag behind in a bullish market.

- Creditors are concerned about the liquidity, solvency, and coverage of your business. They use ratios such as current ratio, quick ratio, debt-to-equity ratio, debt-to-assets ratio, interest coverage ratio, and times interest earned ratio to evaluate how well your business can meet its short-term and long-term obligations, and how much cushion it has to withstand financial shocks. Some recommendations for creditors are:

1. Look for businesses with high current and quick ratios , as they indicate adequate liquidity and working capital management .

2. compare the debt-to-equity and debt-to-assets ratios with the industry average and the nature of the business. A high debt ratio may indicate a high leverage and a low cost of capital, but it may also increase the financial risk and the default probability . A low debt ratio may indicate a low leverage and a high financial strength , but it may also imply a high cost of capital and a low growth potential.

3. Consider the interest coverage and times interest earned ratios, which measure the ability of your business to pay interest expenses from its operating income . A high interest coverage ratio means that your business has a large margin of safety and a low default risk . A low interest coverage ratio means that your business is vulnerable to interest rate changes and financial distress.

- Managers are focused on the efficiency, productivity, and quality of your business. They use ratios such as inventory turnover, days sales in inventory , accounts receivable turnover, days sales outstanding, asset turnover, and return on assets (ROA) to measure how well your business manages its resources, generates sales, and utilizes its assets. Some recommendations for managers are:

1. Look for businesses with high inventory and accounts receivable turnovers, as they indicate fast inventory and credit sales cycles, and low carrying and collection costs.

2. Compare the days sales in inventory and days sales outstanding with the industry average and the credit terms of the business . A low days sales in inventory means that your business has a high inventory turnover and a low obsolescence risk. A high days sales outstanding means that your business has a low accounts receivable turnover and a high bad debt risk.

3. Consider the asset turnover and ROA, which measure the sales generated per unit of asset and the income generated per unit of asset, respectively. A high asset turnover means that your business has a high sales efficiency and a low asset intensity. A high ROA means that your business has a high profit margin and a high asset efficiency.

- Customers are interested in the quality, value, and satisfaction of your products or services . They use ratios such as gross profit margin, net profit margin, customer satisfaction index , customer retention rate, and customer lifetime value to assess how well your business delivers on its promises, meets their needs and expectations, and retains their loyalty. Some recommendations for customers are:

1. Look for businesses with high gross and net profit margins , as they indicate a high quality and a low cost of production, and a high pricing power and a low operating expense, respectively.

2. Compare the customer satisfaction index and customer retention rate with the industry average and the competitors. A high customer satisfaction index means that your business has a high customer loyalty and a low customer churn. A high customer retention rate means that your business has a high repeat purchase and a low customer acquisition cost .

3. Consider the customer lifetime value, which measures the net present value of the future cash flows from a customer over their relationship with your business. A high customer lifetime value means that your business has a high customer profitability and a long customer relationship. A low customer lifetime value means that your business has a low customer profitability and a short customer relationship.

Ratio analysis can help you gain valuable insights into the financial health of your business from different perspectives. However, you need to be careful about the assumptions, limitations, and interpretations of each ratio. You also need to use a combination of ratios, rather than relying on a single one, to get a comprehensive and balanced view of your business. By doing so, you can make better decisions, improve your performance, and achieve your goals.

Before Blockchain Capital, I was cranking out startups like an incubator. Brock Pierce

Read Other Blogs

In the pursuit of success, the role of perseverance cannot be overstated. It is the relentless...

As researchers, we often rely on primary sources to gain insight into a particular topic. Primary...

Customer ambassadors are a pivotal asset in the modern marketing landscape, serving as the bridge...

Basel II, the second of the Basel Accords issued by the Basel Committee on Banking Supervision,...

1. Economic Factors: One crucial aspect of the business environment is the influence of economic...

The allure of gala events is undeniable. From the dazzling decor to the exquisite cuisine, gala...

In the realm of productivity, the act of prioritizing tasks is pivotal to effective time management...

One of the most crucial decisions that startups face is how to price their products or services....

In the evolving landscape of financial services, robo-advisors have emerged as a pivotal...

What You Need to Know About Calculating Financial Ratios for Your Business Plan

Startup Financial Model

$169.00 $99.00 Get Template

Understanding how to calculate financial ratios is essential for crafting a robust business plan. These ratios serve as vital indicators of your company’s financial health , guiding strategic decisions and enhancing your potential for growth. In this article, we’ll explore the key ratios you need to include, how to calculate them effectively, and the insights they provide for your business.

What are financial ratios and why are they important in a business plan?

Definition of financial ratios and their components.

Financial ratios are quantitative measures that provide insights into a company's financial performance and stability. They are derived from the financial data within a business's financial statements, primarily the balance sheet and income statement. Ratios help stakeholders evaluate various aspects of a company's operations, including liquidity, profitability, leverage, and efficiency.

The key components of financial ratios typically include:

• Numerator: The top part of the ratio, which represents a specific financial metric (e.g., net income, total assets).
• Denominator: The bottom part of the ratio, which provides a comparison base (e.g., total liabilities, sales revenue).

Importance of ratios in assessing financial health

Understanding the importance of financial ratios is crucial for any business plan. They serve as vital tools for assessing the financial health of a business, allowing entrepreneurs and investors to make informed decisions. By evaluating financial ratios, stakeholders can identify strengths and weaknesses, gauge operational efficiency, and assess overall financial stability.

Some key reasons why financial ratios are important include:

• They provide a standardized way to compare performance across different periods or against industry benchmarks.
• Ratios help in identifying trends over time, enabling businesses to track their growth or decline.
• They facilitate better communication with investors, lenders, and other stakeholders by providing clear metrics on financial health.

How ratios can guide decision-making and strategic planning

Financial ratios play a crucial role in guiding decision-making and strategic planning within a business. By analyzing key financial ratios, entrepreneurs can uncover insights that inform their strategies and operational adjustments. For instance:

• Liquidity ratios like the current ratio help businesses assess their ability to meet short-term obligations, guiding cash flow management.
• Profitability ratios , such as gross margin and net profit margin, provide insights into pricing strategies and cost management.
• Efficiency ratios , including inventory turnover, indicate how effectively resources are utilized, which can prompt operational improvements.
• Leverage ratios , such as the debt-to-equity ratio, inform decisions regarding financing and risk management.
• Regularly review your financial ratios to stay informed about your business's financial health.
• Benchmark your ratios against industry standards to gain a clearer understanding of your performance.
• Involve your finance team in the calculation and analysis of financial ratios to enhance accuracy and insight.

Related Blogs

• Private Equity and its Role in Startup Funding
• Increase Collection Efficiency & minimise Financial Impact:Knowing How to Manage Debtors
• Harness The Power of Angel Investing For Optimal Portfolio Diversification
• The Basics of Single Entry Bookkeeping - Start Tracking Your Business' Finances Now!
• Unlock the Power of Annual Contract Value (ACV) for Your Business

Which key financial ratios should be included in a business plan?

Overview of liquidity ratios.

Liquidity ratios are essential for assessing a company's ability to meet its short-term obligations. These ratios provide insight into the financial health of a business and its capacity to convert assets into cash quickly. The two primary liquidity ratios to consider are:

• Current Ratio: This ratio compares current assets to current liabilities, indicating whether the business has enough assets to cover its short-term debts. A current ratio above 1 suggests that the company is in a healthy position.
• Quick Ratio: Also known as the acid-test ratio, this measures the ability to meet short-term liabilities without relying on the sale of inventory. It is calculated by subtracting inventory from current assets and then dividing by current liabilities. A quick ratio greater than 1 is generally seen as favorable.

Explanation of profitability ratios

Profitability ratios gauge a company's ability to generate profit relative to its revenue, assets, and equity. These ratios are crucial for investors and stakeholders to understand the business's earning potential. Key profitability ratios include:

• Gross Margin: This ratio represents the percentage of revenue that exceeds the cost of goods sold (COGS). A higher gross margin indicates efficient production and strong pricing strategies.
• Net Profit Margin: This ratio measures how much of each dollar earned translates into profits after all expenses are deducted. A higher net profit margin suggests a more profitable business model.

Discussion on efficiency ratios

Efficiency ratios help assess how well a company utilizes its assets and manages its operations. These ratios are vital for understanding operational performance. Important efficiency ratios include:

• Inventory Turnover: This ratio measures how quickly inventory is sold and replaced over a period. A high inventory turnover ratio indicates effective inventory management and strong sales performance.
• Asset Turnover: This ratio assesses how efficiently a company uses its assets to generate revenue. A higher asset turnover ratio suggests better management of assets in generating sales.

Importance of leverage ratios

Leverage ratios provide insight into the level of debt a business is using to finance its operations and growth. They are crucial for understanding financial risk. The most commonly analyzed leverage ratio is:

• Debt-to-Equity Ratio: This ratio compares a company's total liabilities to its shareholders' equity, indicating the proportion of debt used in financing. A lower debt-to-equity ratio suggests a more stable business with less financial risk, while a higher ratio may indicate potential challenges in managing debt.
• When selecting financial ratios for your business plan, ensure they align with your industry benchmarks to provide context and relevance.
• Regularly update your financial data to maintain accuracy in your ratio calculations, as outdated information can lead to misguided conclusions.

How do you calculate financial ratios effectively?

Step-by-step guide on gathering the necessary financial data.

Calculating financial ratios for your business plan begins with collecting accurate financial data . This data serves as the foundation for all financial analysis and helps ensure that your ratios reflect the true state of your business's financial health. Here are the key steps to gather the necessary information:

• Identify the financial statements required: Typically, you'll need the balance sheet, income statement, and cash flow statement.
• Ensure the data is up-to-date: Use the most recent financial statements to reflect your current financial condition.
• Organize the data: Compile figures relevant to the ratios you plan to calculate, such as total assets, total liabilities, revenue, and net profit.
• Double-check for accuracy: Verify each number against your financial records to avoid errors in your calculations.

Explanation of formulas used for each type of ratio

Once you have gathered your financial data, the next step is to apply the appropriate financial ratio formulas . Here’s a breakdown of some key financial ratios and their calculations:

• Current Ratio: Current Assets / Current Liabilities
• Quick Ratio: (Current Assets - Inventory) / Current Liabilities
• Gross Margin: (Revenue - Cost of Goods Sold) / Revenue
• Net Profit Margin: Net Income / Revenue
• Inventory Turnover: Cost of Goods Sold / Average Inventory
• Asset Turnover: Revenue / Average Total Assets
• Debt-to-Equity Ratio: Total Liabilities / Shareholders' Equity

Tips for ensuring accuracy in calculations

Accuracy in calculating financial ratios is crucial for drawing meaningful insights from your analysis. Here are some tips to enhance the accuracy of your calculations:

• Use consistent accounting methods across all financial statements to ensure comparability.
• Perform calculations multiple times to catch any errors, especially in complex formulas.
• Seek feedback from a financial advisor or accountant to validate your results.
• Document each step of your calculation process for transparency and future reference.

By following these steps to gather financial data, applying the correct formulas, and maintaining accuracy throughout your calculations, you can effectively calculate financial ratios that will provide valuable insights into your business's performance and inform your business strategy moving forward.

What do the financial ratios indicate about your business?

Insights provided by liquidity ratios regarding short-term financial health.

Liquidity ratios are crucial for assessing a company's ability to meet its short-term obligations. These ratios, such as the current ratio and the quick ratio , are indicators of financial stability and operational efficiency. A higher liquidity ratio suggests that a business can cover its current liabilities with its current assets, thus reducing the risk of financial distress.

For example, the current ratio is calculated by dividing current assets by current liabilities. A ratio above 1 typically indicates that the company is in a good position to pay off its debts. Conversely, a quick ratio offers a more stringent measure by excluding inventory from current assets, providing a clearer picture of a company's short-term liquidity.

• Regularly monitor your liquidity ratios to ensure you can respond swiftly to unexpected expenses.

Understanding profitability ratios and their implications for growth

Profitability ratios provide insight into a business's ability to generate profit relative to its revenue, assets, and equity. Key profitability ratios include the gross margin and net profit margin . These ratios not only reveal how efficiently a company is managing its costs but also indicate potential for growth and expansion.

The gross margin ratio, which is calculated by dividing gross profit by total revenue, indicates the percentage of revenue that exceeds the cost of goods sold. A high gross margin signals that a company retains a significant portion of revenue as profit, while the net profit margin reflects the percentage of revenue remaining after all expenses have been deducted. This ratio is crucial for assessing overall profitability and operational efficiency.

• Use profitability ratios to benchmark your performance against competitors and industry standards.

How efficiency ratios can highlight operational effectiveness

Efficiency ratios measure how well a company utilizes its assets and manages its operations. Ratios such as inventory turnover and asset turnover are essential for evaluating operational effectiveness. These ratios provide insights into how effectively a company is using its resources to generate sales.

The inventory turnover ratio indicates how often a company sells and replaces its inventory over a specified period. A higher turnover ratio suggests efficient inventory management and strong demand for products. Similarly, the asset turnover ratio, calculated by dividing total revenue by total assets, assesses how efficiently a company is generating revenue from its assets. A higher ratio indicates effective asset utilization.

• Regularly review your efficiency ratios to identify areas of improvement and optimize operations.

How can financial ratios help in forecasting and budgeting?

Role of historical ratio analysis in predicting future performance.

Analyzing historical financial ratios is an invaluable tool for businesses when it comes to forecasting future performance. By examining past data, companies can identify trends and patterns that may inform their financial outlook. For instance, if a business consistently maintains a strong current ratio , it suggests a stable liquidity position, which can be projected into future periods. Similarly, analyzing profitability ratios like gross margin over time helps in estimating future profitability and operational efficiency.

Techniques for using ratios in budget preparation and resource allocation

Incorporating financial ratios into the budgeting process allows businesses to make more informed decisions regarding resource allocation. Here are some effective techniques:

• Utilize liquidity ratios to ensure that there are enough resources to meet short-term obligations. This aids in creating a budget that maintains operational viability.
• Apply profitability ratios to assess which areas of the business contribute the most to the bottom line, thus guiding strategic investment in those sectors.
• Leverage efficiency ratios to evaluate how effectively resources are being used. For example, a high inventory turnover ratio can indicate that a business should invest more in inventory to meet demand.

Importance of scenario analysis with ratio sensitivity

Scenario analysis is crucial in understanding how changes in key financial ratios can impact a business's financial health. By examining various scenarios—such as changes in sales volume, cost of goods sold, or debt levels—businesses can assess the sensitivity of their financial ratios. This practice helps in preparing for potential risks and opportunities. For example:

• Assessing how a decrease in the debt-to-equity ratio can improve financial stability during economic downturns.
• Evaluating the effects of increased operational costs on profitability ratios , enabling better cost control measures.
• Using historical data to simulate different budget scenarios, allowing businesses to create flexible budgets that adapt to changing conditions.
• Regularly review historical financial ratios to stay informed on trends that may influence future performance.
• Involve multiple stakeholders in the budgeting process to gather diverse perspectives on financial ratio analysis.
• Consider utilizing financial modeling tools to visualize the sensitivity of ratios under varying scenarios.

What are common pitfalls when calculating financial ratios?

Misinterpretation of ratios due to lack of context.

One of the most significant risks when calculating financial ratios is the potential for misinterpretation. Financial ratios, such as the current ratio or debt-to-equity ratio , provide valuable insights, but they must be understood within the broader context of the business and its industry. Ratios can vary widely across sectors, and a seemingly healthy ratio in one industry may indicate distress in another.

For instance, a high gross margin may suggest a profitable business model, but without understanding the competitive landscape or the cost structure, this figure can be misleading. Similarly, liquidity ratios need to be evaluated against the business's operational needs and cash flow cycles to understand their true implications.

Over-reliance on ratios without considering qualitative factors

While financial ratios serve as essential indicators of a company's performance, placing too much emphasis on these numbers can lead to poor decision-making. It is crucial to complement quantitative analysis with qualitative insights. Factors such as management experience, market trends, and customer satisfaction can significantly influence business performance.

For example, a company might have a low inventory turnover ratio, which could imply inefficiency. However, if the business is in a transitional phase—like launching a new product line—this situation may not reflect poor management but rather a strategic pivot that requires time to materialize. Thus, qualitative understanding is vital for a well-rounded analysis.

Importance of benchmarking ratios against industry standards

Benchmarking financial ratios against industry standards is crucial for evaluating a company's performance accurately. Without this perspective, businesses risk drawing erroneous conclusions about their financial health. For instance, a profitability ratio that appears satisfactory in isolation may be underwhelming when compared to industry peers.

Using industry benchmarks allows businesses to identify areas of strength and weakness. It provides context to the numbers and helps stakeholders understand how well the business performs relative to its competition. When developing a business plan, including a comparison of key financial ratios against industry averages can be instrumental in highlighting strategic areas for improvement or investment.

• Always contextualize financial ratios within the industry and operational environment.
• Combine quantitative data with qualitative factors for a more comprehensive analysis.
• Utilize industry benchmarks to evaluate and interpret your financial ratios effectively.

7 How can you present financial ratios in your business plan?

Best practices for visual representation (charts, graphs).

Presenting financial ratios in a visually appealing format can significantly enhance comprehension and engagement. Utilize charts and graphs to illustrate key financial ratios effectively. Here are some best practices:

• Use bar charts for comparing different financial ratios across time periods or against industry benchmarks.
• Employ pie charts to represent the composition of profitability ratios, such as gross margin versus operating expenses.
• Incorporate line graphs to illustrate trends in liquidity ratios, like the current ratio over several quarters.
• Utilize color coding to differentiate between various types of ratios, making it easier for stakeholders to identify critical data points.
• Keep visualizations simple and uncluttered to avoid overwhelming your audience.
• Label all axes and data points clearly to enhance understanding.

How to explain ratios clearly to stakeholders

When presenting financial ratios, clarity is key. Stakeholders may not always have a financial background, so it’s important to explain the ratios in a straightforward manner:

• Begin with a brief definition of each ratio and its significance. For example, explain the current ratio as an indicator of short-term liquidity.
• Provide context by comparing the ratios to industry standards or historical performance to illustrate their relevance.
• Use real-life examples or scenarios to illustrate how these ratios might impact business decisions, such as using the debt-to-equity ratio to assess financial leverage.
• Encourage questions and discussions to ensure stakeholders grasp the implications of the ratios presented.
• Practice your presentation to ensure you can explain complex concepts in simple terms.
• Prepare supplementary materials for stakeholders to reference later, including glossaries or FAQs on financial ratios.

Integrating ratio analysis into overall business strategy narrative

Financial ratios should not exist in isolation; they are integral to your overall business strategy narrative. Here’s how to weave them into your business plan:

• Align ratio analysis with your company’s strategic goals. For instance, if a goal is to improve operational efficiency, highlight your efficiency ratios like inventory turnover.
• Link the financial ratios to actionable insights. Discuss how improving a gross margin can enable reinvestment in growth initiatives.
• Incorporate a forecasting component by projecting how changes in financial ratios can influence future performance, such as predicting how an improved net profit margin could enhance cash flow.
• Regularly revisit and revise your narrative as financial ratios evolve, ensuring that your strategy remains aligned with your financial health assessments.
• Maintain a narrative that reflects both quantitative (ratios) and qualitative (strategic goals) aspects of your business.
• Use case studies or testimonials to bolster your narrative when discussing ratios and their strategic implications.

Leave a comment

Your email address will not be published. Required fields are marked *

Please note, comments must be approved before they are published

• Search Search Please fill out this field.

What Is Ratio Analysis?

• How It Works
• Limitations
• Application

The Bottom Line

• Corporate Finance
• Financial Ratios

Financial Ratio Analysis: Definition, Types, Examples, and How to Use

• Business Valuation: 6 Methods for Valuing a Company
• Valuation Analysis
• Financial Statements
• Balance Sheet
• Cash Flow Statement
• 6 Basic Financial Ratios
• 5 Must-Have Metrics for Value Investors
• Earnings Per Share (EPS)
• Price-to-Earnings Ratio (P/E Ratio)
• Price-To-Book Ratio (P/B Ratio)
• Price/Earnings-to-Growth (PEG Ratio)
• Fundamental Analysis
• Absolute Value
• Relative Valuation
• Intrinsic Value of a Stock
• Intrinsic Value vs. Current Market Value
• Equity Valuation: The Comparables Approach
• 4 Basic Elements of Stock Value
• How to Become Your Own Stock Analyst
• Due Diligence in 10 Easy Steps
• Determining the Value of a Preferred Stock
• Qualitative Analysis
• Stock Valuation Methods
• Bottom-Up Investing
• Ratio Analysis CURRENT ARTICLE
• What Book Value Means to Investors
• Liquidation Value
• Market Capitalization
• Discounted Cash Flow (DCF)
• Enterprise Value (EV)
• How to Use Enterprise Value to Compare Companies
• How to Analyze Corporate Profit Margins
• Return on Equity (ROE)
• Decoding DuPont Analysis
• How to Value Private Companies
• Valuing Startup Ventures

Ratio analysis is a method of examining a company's balance sheet and income statement to learn about its liquidity, operational efficiency, and profitability. It doesn't involve one single metric; instead, it is a way of analyzing a variety of financial data about a company. Ratio analysis is a cornerstone of fundamental equity analysis .

There are many different ratios that investors and other business experts can analyze to make predictions about a company's financial stability and potential future growth. These can be used to evaluate either how a company's performance has changed over time or how it compares to other businesses in its industry.

Key Takeaways

• Ratio analysis compares line-item data from a company's financial statements to evaluate it profitability, liquidity, efficiency, and solvency.
• Ratio analysis can track how a company is performing over time or how it compares to another business in the same industry or sector.
• Ratio analysis may also be required by external parties that set benchmarks often tied to risk, such as lenders.
• While ratios offer useful insight into a company, they should be paired with other metrics to obtain a broader picture of a company's financial health.
• Examples of ratio analysis include the current ratio, gross profit margin ratio, and inventory turnover ratio.

Investopedia / Theresa Chiechi

How Ratio Analysis Works

Investors and analysts use ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. For example, comparing the price per share to earnings per share allows investors to find the price-to-earnings (P/E) ratio , a key metric for determining the value of a company's stock.

The ratios of these different financial metrics from a company can be used to:

• Evaluate a company's performance over time
• Estimate likely future performance
• Compare a company's financial standing with industry averages
• Measuring how a company stacks up against others within the same sector

Every figure needed to calculate the ratios used in ratio analysis is found on a company's financial statements.

A ratio is the relation between two amounts showing the number of times one value contains or is contained within the other.

Ratios are comparison points for companies and are not generally used in isolation. Instead, they are compared either to past ratios for the same company or to the same ratio from other companies.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven is probably undervalued. In contrast, one with a P/E ratio of 50 likely is overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.

Ratio analysis is often used by investors, but it can also be used by the company itself to evaluate how strategic changes have impacted sales, growth, and performance.

Limitations of Ratio Analysis

Ratio analysis can help investors understand a company's current performance and likely future growth. However, companies can make small changes that make their stock and company ratios more attractive without changing any underlying financial fundamentals. To counter this limitation, investors also need to understand the variables behind ratios, what information they do and do not communicate, and how they are susceptible to manipulation.

Ratios also can't be used in isolation. Instead, they should be used in combination with other ratios or financial metrics to give a fuller picture of both a company's financial state and how it compares to other companies in the same industry.

Types of Ratios for Ratio Analysis

The financial ratios available can be broadly grouped into six types based on the kind of data they provide. Using ratios in each category will give you a comprehensive view of the company from different angles and help you spot potential red flags.

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include:

• Current ratio
• Quick ratio
• Working capital ratio

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings. These are used to evaluate the likelihood of a company staying afloat over the long haul by paying off both long-term debt and the interest on that debt. Examples of solvency ratios include:

• Debt-equity ratios
• Debt-assets ratios
• Interest coverage ratios

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Examples of profitability ratios are:

• Profit margin ratio
• Return on assets
• Return on equity
• Return on capital employed
• Gross margin ratio

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include:

• Turnover ratio
• Inventory turnover
• Day's sales in inventory

5. Coverage Ratios

Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include:

• Times interest earned ratio
• Debt-service coverage ratio

6. Market Prospect Ratios

Market prospect ratios are the most commonly used ratios in fundamental analysis. Investors use these metrics to predict earnings and future performance. These ratios include:

• Dividend yield
• Earnings per share (EPS)
• Dividend payout ratio

Most ratio analysis is only used for internal decision making. Though some benchmarks are set externally (discussed below), ratio analysis is often not a required aspect of budgeting or planning.

Application of Ratio Analysis

Using ratio analysis will give you multiple figures and values to compare. However, those values will mean very little in isolation. Instead, the values derived from these ratios should be compared to other data to determine whether a company's financial health is strong, weak, improving, or deteriorating.

Ratio Analysis Over Time

Comparing how the same ratio changes over time provides a picture of how a company has performed during that period, what risks might exist in the future, and what growth trajectory growth it is likely to follow.

To perform ratio analysis over time, select a single financial ratio, then calculate that ratio at set intervals (for example, at the beginning of every quarter). Then, analyze how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).

When performing ratio analysis over time, be mindful of seasonality and how temporary fluctuations may impact month-over-month ratio calculations.

Comparative Ratio Analysis Across Companies

Comparative ratio analysis can be used to understand how a company's performance compares to similar companies in the same industry. For example, a company with a 10% gross profit margin may be in good financial shape if other companies in the same sector have gross profit margins of 5%. However, if the majority of competitors achieve gross profit margins of 25%, that's a sign that the original company may be in financial trouble.

When using ratio analysis to compare different companies, be sure to:

• Only analyze similar companies within the same industry .
• Be mindful of how different capital structures and company sizes may impact a company's ability to be efficient.
• Consider the impact of varying product lines (for example, two companies offer similar services, but only one sells physical products).

Different industries have different ratio expectations. A debt-equity ratio that might be normal for a utility company that can obtain low-cost debt might be deemed unsustainably high for a technology company that relies more heavily on private investor funding.

Ratio Analysis Against Benchmarks

Companies may set internal targets for their financial ratios. The goal may be to hold current levels steady or to strive for operational growth. For example, a company's existing current ratio may be 1.1; if the company wants to become more liquid, it may set the internal target of having a current ratio of 1.2 by the end of the fiscal year.

Benchmarks are also frequently implemented by external parties such as lenders. Lending institutions often set requirements for financial health as part of covenants in loan document's terms and conditions. An example of a benchmark set by a lender is often the debt service coverage ratio, which measures a company's cash flow against its debt balances. If a company doesn't maintain certain levels for these ratios, the loan may be recalled or the interest rate attached to that loan may increase.

Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance — for better or worse. When a company generally boasts solid ratios in all areas, any sudden hint of weakness in one area may spark a significant stock sell-off.

For example, net profit margin , often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It's calculated by dividing a company's net income by its revenues and is often used instead of dissecting financial statements to compare how profitable companies are. If company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively, an investor comparing the two companies will conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.

This can be combined with additional ratios to learn more about the companies in question. If ABC has a P/E ratio of 100 and DEF has a P/E ratio of 10, that means investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

What Are the Types of Ratio Analysis?

Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios. Other non-financial metrics may be scattered across various departments and industries. For example, a marketing department may use a conversion click ratio to analyze customer capture.

What Are the Uses of Ratio Analysis?

Ratio analysis serves three main uses. First, ratio analysis can be performed to track changes within a company's financial health over time and predict future performance. Second, ratio analysis can be performed to compare results between competitors. Third, ratio analysis can be performed to strive for specific internally-set or externally-set benchmarks.

Why Is Ratio Analysis Important?

Ratio analysis can be used to understand the financial and operational health of a company; static numbers on their own may not fully explain how a company is performing. Consider a business that made $1 billion in revenue last quarter. Though this seems ideal, the company might have had a negative gross profit margin, a decrease in liquidity ratio metrics, and lower earnings compared to equity than in prior periods. This means the company is performing below its competitors in spite of its high revenue.

What Is an Example of Ratio Analysis?

Consider the inventory turnover ratio that measures how quickly a company converts inventory to a sale. A company can track its inventory turnover over a full calendar year to see how quickly it converted goods to cash each month. Then, a company can explore the reasons certain months lagged or why certain months exceeded expectations.

There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their information, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Ratio analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.

• Terms of Service
• Editorial Policy
• Privacy Policy
• Your Privacy Choices

Plan Projections

ideas to numbers .. simple financial projections

Home > Financial Projections > Financial Ratios Analysis

Financial Ratios Analysis

When developing financial projections for your business plan it is useful to monitor the financial ratios produced so that they can be compared with other available data. By making the comparisons it is possible to see whether your financial projections are in line with industry, competitor, and if available, historical data. If the financial ratio comparisons reveal unexplained variations then the assumptions in the plan need to be improved and fine tuned to bring the projections in line with expectations.

What are Financial Ratios

One financial ratio viewed in isolation will not tell you a great deal about a business. The key to using financial ratios is to chose the ratios which are most critical to your business, decide on the formula to use, which should be the same as that used by comparable businesses in your industry, and consistently monitor the ratio over time relative to other ratios you have calculated.

Key Financial Ratios

Financial ratios can be split into six main categories

• Profitability Ratios
• Liquidity Ratios
• Efficiency ratios
• Leverage Ratios
• Activity ratios
• Investor ratios

Profitability Financial Ratios

The profitability ratios are used to measure the ability of a business and its management to generate profit and the following financial ratios are included and calculated for you in the financial projections template:

• Gross margin percentage
• Operating expenses ratio
• Return on sales
• Net profit ratio
• Return on capital employed (ROCE)

Profitability Ratio Example – Gross margin Percentage

The numbers used in the calculation of the gross margin percentage are highlighted in the income statement shown above.

Efficiency Financial Ratios

Efficiency ratios are used to measure the ability of a business to control and manage its assets to produce the maximum amount of revenue and profit from them. The following financial ratios are included and calculated for you in the financial projections template:

• Asset turnover ratio
• Fixed asset turnover ratio
• Working capital turnover ratio

Efficiency Ratio Example – Asset Turnover Ratio

The asset turnover ratio shows the revenue generated by the assets of your business. It is a measure of the efficiency with which the business uses its resources. It is calculated by dividing revenue by assets

The numbers used in the calculation of the gross margin percentage are highlighted in the income statement and balance sheet shown above.

Liquidity Financial Ratios

A liquidity ratio is used to measure the ability of a business to generate cash to meet its short term liabilities and debts. The following financial ratios are included and calculated for you in the financial projections template:

• Current ratio
• Quick ratio

Liquidity Ratio Example – Current Ratio

The current ratio measures the liquidity of a business and its ability to meet its short term liabilities and debts. It is calculated by dividing current assets by current liabilities.

The numbers used in the calculation of the current ratio are highlighted in the balance sheet shown above.

Leverage Financial Ratios

A leverage ratio is used to show the capital structure of the business and in particular the level of debt in relation to owners equity. A business with a high level of debt is considered to be more risky but will give greater returns to the owners provided cash and profit are managed correctly. The following financial ratios are included and calculated for you in the financial projections template:

• Gearing ratio
• Debt equity ratio
• Times interest earned

Leverage Ratio Example – Debt Equity Ratio

The debt equity ratio is the ratio of how much a business owes (debt) compared to how much the owners have invested (equity). It is calculated by dividing debt by owners equity.

The numbers used in the calculation of the debt equity ratio are highlighted in the balance sheet shown above.

Note in this example there is only long term debt shown in the balance sheet, in practice all forms of debt should be included in the calculation.

Leverage ratios assess a businesses ability to pay off long-term debt including obligations to creditors, bondholders, and banks and for this reason are sometimes referred to as solvency ratios .

Activity Financial Ratios

Activity ratios are used to measure the ability of a business to convert different balance sheet accounts such as inventory, accounts receivable, and accounts payable into cash or sales. The following financial ratios are included and calculated for you in the financial projections template:

• Accounts receivable days ratio
• Accounts payable days ratio
• Inventory days

Activity Ratio Example – Accounts Receivable Days Ratio

The accounts receivable days ratio shows the average number of days your customers are taking to pay you. It is calculated by dividing accounts receivable by average daily sales.

Note: In this example the closing balance sheet is used to obtain the value of accounts receivable. If available, it is good practice to use values from both the opening and closing balance sheets to give an average value fro accounts receivable.

Investor Financial Ratios Analysis

Investor ratios are used to measure the ability of a business to earn an adequate return for the owners of the business. The owners have money tied up in the business and need a return commensurate with the risk involved. The following financial ratios are included and calculated for you in the financial projections template:

• Return on Equity (ROE)
• Dividend cover

Investor Ratio Example – Return on Equity (ROE)

The return on equity measures the percentage rate of return the owner of a business gets on their investment. It is calculated by dividing the net income by the owners equity.

The numbers used in the calculation of the return on equity are highlighted in the income statement and balance sheet shown above.

Financial ratios are derived from information included in the income statements and balance sheets of the business plan financial projections. The ratios are used as indicators of the the financial health of the business and for comparing the performance of the business with other businesses in the same sector, and can be used to fine tune the financial projections.

When the financial projections have been prepared, equity investors , providers of debt finance, and many trade credit suppliers will use financial ratios analysis to assess the business to decide whether or not to invest, provide loan facilities or to extend credit to the business.

About the Author

Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

You May Also Like

• What is a Business Plan
• Table of Contents
• Executive Summary
• Mission Statement
• Marketing Section
• Operating Plan
• Management & Staffing Section
• Financial Section
• Business Plan Tips
• Income Statement
• Balance Sheet
• Cash Flow Statement
• Break-even Analysis
• Ratio Analysis
• Sensitivity Analysis
• Notes to Financials
• Financial Budgets
• Forecasting Cash Flow
• Break-Even Analysis
• Operation Issues
• Marketing Issues
• Licenses, Permits, Inspections & Taxes
• Management/Staffing
• Financial Issues

Main Menu Items

Home Writing a Business Plan Financial Statements Forecasting Statements Business Checklist

Introduction to Ratio Analysis

• Email a Friend

INTRODUCTION TO RATIO ANALYSIS

A general technique for analyzing a business's performance or its potential performance is known as Ratios Analysis. Ratio Analysis involves calculating ratios for a business or proposed business and comparing them to ratios of other businesses within the same industry.

Ratios involve dividing numbers from a business' Balance Sheet and Income Statement to create percentages and decimals. When existing businesses apply for a loan, for example, bankers will look at the company's ratios and compare them to ratios of other businesses within the same industry. This will determine how "stable" the company is compared to other businesses within the same industry. Moreover, ratio analysis will assist investors in determining three things about an existing business:

In addition, bankers and educated investors will compare ratios of non-existing businesses (aspiring entrepreneurs planning on establishing a business) to businesses already existing within the industry to determine if the proposed business will be competitive . Moreover, ratio analysis will show investors three things regarding the performance of a potential business venture;

1. How the aspiring entrepreneur anticipates his or her business will perform in their third year of operations;

2. How the aspiring entrepreneur anticipates his or her business will be performing in the first two years of operations; and

3. How the aspiring entrepreneur's business will compare to other businesses already operating within the industry.

Both existing business owners and potential business owners should calculate their own ratios. This will help to determine how well they are performing or plan to perform internally and externally. In addition, ratios are generally required in a business plan and will be closely scrutinized by bankers and other educated investors.

This section has been organized into three parts, namely;

To help us in our discussions, we will use a fictitious company called "The Widget Manufacturing Company". In Part 1, you will learn how to calculate ratios for The Widget Manufacturing Company for 200Y. Part 2 involves calculating the company's 200X ratios and comparing them to the company's 200Y ratios. This will assist in determining whether or not the company is improving its performance. In Part 3, we will compare the company's 200Y ratios to the ratios of an average business within the industry. Moreover, Part 3 will determine how well the company is performing in relation to other businesses within the same industry.

Please Note: Do not attempt to memorize the ratio formulas, rather focus your attention on what each ratio means. This will enable you to intelligently draw conclusions for the Widget Manufacturing Company as well as for your own business or proposed business venture.

Lets now begin our ratio analysis discussion, starting with PART 1 "Calculating Ratios". Good Luck and have fun.

Sign up for the newsletter!

FREE Marketing Guide

© Copyright 2009 - Business Plan Hut - All Rights Reserved

  About - Contact Us - Privacy Policy - Disclaimer - Sitemap - Login - Admin

• Search Please fill out this field.
• Building Your Business
• Operations & Success

Financial Ratio Analysis Tutorial With Examples

The Balance Sheet for Financial Ratio Analysis

The income statement for financial ratio analysis, analyzing the liquidity ratios, the current ratio, the quick ratio, analyzing the asset management ratios accounts receivable, receivables turnover, average collection period, inventory, fixed assets, total assets, inventory turnover ratio, fixed asset turnover, total asset turnover, analyzing the debt management ratios, debt-to-asset ratio, times interest earned ratio, fixed charge coverage, analyzing the profitability ratios, net profit margin, return on assets, return on equity, financial ratio analysis of xyz corporation.

While it may be more fun to work on marketing efforts, the financial management of a firm is a crucial aspect of owning a business. Financial ratios help break down complex financial information into key details and relationships. Financial ratio analysis involves studying these ratios to learn about the company's financial health.

Here are a few of the most important financial ratios for business owners to learn, what they tell you about the company's financial statements, and how to use them.

Key Takeaways

• Some of the most important financial ratios for business owners include the current ratio, the inventory turnover ratio, and the debt-to-asset ratio.
• These financial ratios quickly break down the complex information from financial statements .
• Financial ratios are snapshots, so it's important to compare the information to previous periods of data as well as competitors in the industry.

Here is the balance sheet we are going to use for our financial ratio tutorial. You will notice there are two years of data for this company so we can do a time-series (or trend) analysis and see how the firm is doing across time.

Here is the complete income statement for the firm for which we are doing financial ratio analysis. We are doing two years of financial ratio analysis for the firm so we can compare them.

Refer back to the income statement and balance sheet as you work through the tutorial.

The first ratios to use to start getting a financial picture of your firm measure your liquidity, or your ability to convert your current assets to cash quickly. They are two of the 13 ratios. Let's look at the current ratio and the quick (acid-test) ratio .

The current ratio measures how many times you can cover your current liabilities. The quick ratio measures how many times you can cover your current liabilities without selling any inventory and so is a more stringent measure of liquidity.

Remember that we are doing a time series analysis, so we will be calculating the ratios for each year.

Current Ratio : For 2022, take the Total Current Assets and divide them by the Total Current Liabilities. You will have: Current Ratio = 642/543 = 1.18X. This means that the company can pay for its current liabilities 1.18 times over. Practice calculating the current ratio for 2023.

Your answer for 2023 should be 1.31X. A quick analysis of the current ratio will tell you that the company's liquidity has gotten just a little bit better between 2022 and 2023 since it rose from 1.18X to 1.31X.

Quick Ratio : In order to calculate the quick ratio, take the Total Current Ratio for 2022 and subtract out Inventory. Divide the result by Total Current Liabilities. You will have: Quick Ratio = (642-393)/543 = 0.46X. For 2023, the answer is 0.52X.

Like the current ratio, the quick ratio is rising and is a little better in 2023 than in 2022. The firm's liquidity is getting a little better. The problem for this company, however, is that they have to sell inventory to pay their short-term liabilities and that is not a good position for any firm to be in. This is true in both 2022 and 2023.

This firm has two sources of current liabilities: accounts payable and notes payable. They have bills that they owe to their suppliers (accounts payable) plus they apparently have a bank loan or a loan from some alternative source of financing. We don't know how often they have to make a payment on the note.

Asset management ratios are the next group of financial ratios that should be analyzed. They tell the business owner how efficiently they employ their assets to generate sales. Assume all sales are on credit.

• Receivables Turnover = Credit Sales/Accounts Receivable
• Receivables Turnover = 2,311/165 = 14X

A receivables turnover of 14X in 2022 means that all accounts receivable are cleaned up (paid off) 14 times during the 2022 year. For 2023, the receivables turnover is 15.28X. Look at 2022 and 2023 Sales in The Income Statement and Accounts Receivable in The Balance Sheet.

The receivables turnover is rising from 2022 to 2023. We can't tell if this is good or bad. We would really need to know what type of industry this firm is in and get some industry data to compare to.

Customers paying off receivables is, of course, good. But, if the receivables turnover is way above the industry's, then the firm's credit policy may be too restrictive.

The average collection period is also about accounts receivable. It is the number of days, on average, that it takes a firm's customers to pay their credit accounts. Together with receivables turnover, the average collection helps the firm develop its credit and collections policy.

• Average Collection Period = Accounts Receivable/Average Daily Credit Sales
• To arrive at average daily credit sales, take credit sales and divide by 360
• Average Collection Period = $165/2,311/360 = $165/6.42 = 25.7 days
• In 2023, the average collection period is 23.5 days

From 2022 to 2023, the average collection period is dropping. In other words, customers are paying their bills more quickly. Compare that to the receivables turnover ratio. Receivables turnover is rising and the average collection period is falling.

This makes sense because customers are paying their bills faster. The company needs to compare these two ratios to industry averages. In addition, the company should take a look at its credit and collections policies to be sure they are not too restrictive. Take a look at the image above and you can see where the numbers came from on the balance sheets and income statements.

Along with the accounts receivable ratios that we analyzed above, we also have to analyze how efficiently we generate sales with our other assets: inventory, plant and equipment, and our total asset base.

The inventory turnover ratio is one of the most important ratios a business owner can calculate and analyze. If your business sells products as opposed to services, then inventory is an important part of your equation for success.

Inventory Turnover = Sales/Inventory

If your inventory turnover is rising, that means you are selling your products faster. If it is falling, you are in danger of holding obsolete inventory. A business owner has to find the optimal inventory turnover ratio where the ratio is not too high and there are no stockouts or too low where there is obsolete money. Both are costly to the firm.

For this company, their inventory turnover ratio for 2022 is:

Inventory Turnover Ratio = Sales/Inventory = 2,311/393 = 5.9X

This means that this company completely sells and replaces its inventory 5.9 times every year. In 2023, the inventory turnover ratio is 6.8X. The firm's inventory turnover is rising. This is good in that they are selling more products. The business owner should compare the inventory turnover with the inventory turnover ratio of other firms in the same industry.

The fixed asset turnover ratio analyzes how well a business uses its plant and equipment to generate sales. A business firm does not want to have either too little or too much plant and equipment. For this firm for 2022:

Fixed Asset Turnover = Sales/Fixed Assets = 2,311/2,731 = 0.85X

For 2023, the fixed asset turnover is 1.00. The fixed asset turnover ratio is dragging down this company. They are not using their plant and equipment efficiently to generate sales as, in both years, fixed asset turnover is very low.

The total asset turnover ratio sums up all the other asset management ratios. If there are problems with any of the other total assets, it will show up here, in the total asset turnover ratio.

Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets = 2,311/3,373 = 0.69X for 2022. For 2023, the total asset turnover is 0.80. The total asset turnover ratio is somewhat concerning since it was not even 1X for either year.

This means that it was not very efficient. In other words, the total asset base was not very efficient in generating sales for this firm in 2022 or 2023. Why?

It seems that most of the problem lies in the firm's fixed assets. They have too much plant and equipment for their level of sales. They either need to find a way to increase their sales or sell off some of their plant and equipment. The fixed asset turnover ratio is dragging down the total asset turnover ratio and the firm's asset management in general.

There are three debt management ratios that help a business owner evaluate the company in light of its asset base and earning power. Those ratios are the debt-to-asset ratio, the times interest earned ratio , and the fixed charge coverage ratios. Other debt management ratios exist, but these help give business owners the first look at the debt position of the company and the prudence of that debt position.

The first debt ratio that is important for the business owner to understand is the debt-to-asset ratio ; in other words, how much of the total asset base of the firm is financed using debt financing. For example. the debt-to-asset ratio for 2022 is:

Total Liabilities/Total Assets = $1,074/3,373 = 31.8%. This means that 31.8% of the firm's assets are financed with debt. In 2023, the debt ratio is 27.8%. In 2023, the business is using more equity financing than debt financing to operate the company.

We don't know if this is good or bad since we do not know the debt-to-asset ratio for firms in this company's industry. However, we do know that the company has a problem with its fixed asset ratio which may be affecting the debt-to-asset ratio.

The times interest earned ratio tells a company how many times over a firm can pay the interest that it owes. Usually, the more times a firm can pay its interest expense the better. The times interest earned ratio for this firm for 2022 is:

• Times Interest Earned = Earnings Before Interest and Taxes/Interest = 276/141 = 1.96X
• For 2023, the times interest earned ratio is 3.35

The times interest earned ratio is very low in 2022 but better in 2023. This is because the debt-to-asset ratio dropped in 2023.

The fixed charge coverage ratio is very helpful for any company that has any fixed expenses they have to pay. One fixed charge (expense) is interest payments on debt, but that is covered by the times interest earned ratio.

Another fixed charge would be lease payments if the company leases any equipment, a building, land, or anything of that nature. Larger companies have other fixed charges which can be taken into account.

• Fixed charge coverage = Earnings Before Fixed Charges and Taxes/Fixed Charges

In both 2022 and 2023 for the company in our example, its only fixed charge is interest payments. So, the fixed charge coverage ratio and the times interest earned ratio would be exactly the same for each year for each ratio.

The last group of financial ratios that business owners usually tackle are the profitability ratios as they are the summary ratios of the 13 ratio group. They tell the business firm how they are doing on cost control, efficient use of assets, and debt management, which are three crucial areas of the business.

The net profit margin measures how much each dollar of sales contributes to profit and how much is used to pay expenses. For example, if a company has a net profit margin of 5%, this means that 5 cents of every sales dollar it takes in goes to profit and 95 cents goes to expenses. For 2022, here is XYZ, Inc.'s net profit margin:

Net Profit Margin = Net Income/Sales Revenue = 89.1/2,311 = 3.9%

For 2023, the net profit margin is 6.5%, so there was quite an increase in their net profit margin. You can see that their sales took quite a jump but their cost of goods sold rose. It is the best of both worlds when sales rise and costs fall. Bear in mind: The company can still have problems even if this is the case.

The return on assets ratio, also called return on investment , relates to the firm's asset base and what kind of return they are getting on their investment in their assets. Look at the total asset turnover ratio and the return on asset ratio together. If total asset turnover is low, the return on assets is going to be low because the company is not efficiently using its assets.

Another way to look at the return on assets is in the context of the Dupont method of financial analysis. This method of analysis shows you how to look at the return on assets in the context of both the net profit margin and the total asset turnover ratio.

• To calculate the Return on Assets ratio for XYZ, Inc. for 2022, here's the formula:
• Return on Assets = Net Income/Total Assets = 2.6%

For 2023, the ROA is 5.2%. The increased return on assets in 2023 reflects the increased sales and much higher net income for that year.

The return on equity ratio is the one of most interest to the shareholders or investors in the firm. This ratio tells the business owner and the investors how much income per dollar of their investment the business is earning. This ratio can also be analyzed by using the Dupont method of financial ratio analysis. The company's return on equity for 2022 was:

Return on Equity = Net Income/Shareholder's Equity = 3.9%

For 2023, the return on equity was 7.2%. One reason for the increased return on equity was the increase in net income. When analyzing the return on equity ratio, the business owner also has to take into consideration how much of the firm is financed using debt and how much of the firm is financed using equity.

Now we have a summary of all 13 financial ratios for XYZ Corporation. The first thing that jumps out is the low liquidity of the company. We can look at the current and quick ratios for 2022 and 2023 and see that the liquidity is slightly increasing between 2022 and 2023, but it is still very low.

By looking at the quick ratio for both years, we can see that this company has to sell inventory in order to pay off short-term debt. The company does have short-term debt: accounts payable and notes payable, and we don't know when the notes payable will come due.

Let's move on to the asset management ratios. We can see that the firm's credit and collections policies might be a little restrictive by looking at the high receivable turnover and low average collection period. Customers must pay this company rapidly—perhaps too rapidly. There is nothing particularly remarkable about the inventory turnover ratio, but the fixed asset turnover ratio is remarkable.

The fixed asset turnover ratio measures the company's ability to generate sales from its fixed assets or plant and equipment. This ratio is very low for both 2022 and 2023. This means that XYZ has a lot of plant and equipment that is unproductive.

It is not being used efficiently to generate sales for the company. In addition, the company has to service the plant and equipment, pay for breakdowns, and perhaps pay interest on loans to buy it through long-term debt.

It seems that a very low fixed asset turnover ratio might be a major source of problems for XYZ. The company should sell some of this unproductive plant and equipment, keeping only what is absolutely necessary to produce their product.

The low fixed asset turnover ratio is dragging down total asset turnover. If you follow this analysis through, you will see that it is also substantially lowering this firm's return on assets profitability ratio.

With this firm, it is hard to analyze the company's debt management ratios without industry data. We don't know if XYZ is a manufacturing firm or a different type of firm.

As a result, analyzing the debt-to-asset ratio is difficult. What we can see, however, is that the company is financed more with shareholder funds (equity) than it is with debt as the debt-to-asset ratio for both years is under 50% and dropping.

This fact means that the return on equity profitability ratio will be lower than if the firm was financed more with debt than with equity. On the other hand, the risk of bankruptcy will also be lower.

Unfortunately, you can see from the times interest earned ratio that the company does not have enough liquidity to be comfortable servicing its debt. The company's costs are high and liquidity is low. Fortunately, the company's net profit margin is increasing because their sales are increasing.

Hopefully, this is a trend that will continue. Return on Assets is impacted negatively due to the low fixed asset turnover ratio and, to some extent, by the receivables ratios. Return on equity is increasing from 2022 to 2023, which will make investors happy.

As you can see, it is possible to do a cursory financial ratio analysis of a business firm with only 13 financial ratios, even though ratio analysis has inherent limitations.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.2 Operating Efficiency Ratios ." OpenStax.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 2, 4.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 6.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.4 Solvency Ratios ." OpenStax.

Nasdaq. " Fixed-Charge Coverage Ratio ."

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 5.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.6 Profitability Ratios and the DuPont Method ." OpenStax.

Related Articles