Understanding financial ratios
As a business owner or entrepreneur, understanding your business’s financial health is crucial to its success. Financial ratios are essential tool that can help you better understand your business’s financial performance and make informed decisions about its future.
Financial ratios are mathematical calculations that compare two or more financial variables to understand better how your business is performing financially. These ratios can measure and compare different aspects of a business’s financial performance, such as its profitability, liquidity, and solvency.
Key financial ratios for business owners and entrepreneurs
There are several financial ratios a business can study and analyze, but here are the primary financial ratios that business owners and entrepreneurs should understand and use in their companies:
This ratio measures a business’s ability to pay its short-term debts with current assets. It is derived and computed by dividing current assets by current liabilities, as shown below:
Current Ratio = Current Assets / Current Liabilities
The current ratio can be a valuable tool to assess whether the company has enough liquidity to meet its short-term obligations, such as paying bills and covering expenses.
The ideal current ratio for most businesses is between 1.5 and 3. For every euro of current liabilities, the company should have at least €1.50 to €3.00 of current assets to cover these obligations. A current ratio below one may indicate that the business may struggle to meet its short-term obligations.
By maintaining a healthy current ratio, the business can focus on its long-term growth and success without worrying about potential cash flow issues or needing to take on debt to cover its short-term obligations.
This ratio compares a business’s total debt to its total Equity. It is computed by dividing total debt by total equity, as follows:
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
A lower ratio is generally considered better, as it shows that the business has a more stable financial structure with less risk. This helps a company attract investors and lenders and provides financial flexibility for long-term growth and expansion.
The ideal debt-to-equity ratio varies depending on the industry and the business’s life cycle stage. For most companies, a debt-to-equity ratio of 1 or less is considered healthy, indicating that the business is not relying too heavily on debt to finance its operations. However, some industries, such as real estate and utilities, may have higher debt-to-equity ratios due to their capital-intensive nature.
Gross profit margin
This ratio measures the percentage of sales revenue after deducting the cost of sales. It is derived by dividing gross profit by total revenue.
Gross Profit Margin = ( Revenue – Cost of Sales) / Revenue
A high gross profit margin shows that a company provides a substantial profit on each unit of product or service sold. This can help ensure the continuity and success of a business because it allows for more financial resources for reinvestment, growth, and expansion. Conversely, a low gross profit margin may indicate that a company is not pricing its products or services effectively or may be facing competitive pressures that limit its pricing power.
The ideal gross profit margin varies depending on the industry and the business’s pricing strategy. Generally, a 30% or higher gross profit margin is considered suitable for most companies, as it indicates that the business can generate enough revenue to cover its production costs and still make a profit.
Net profit margin
This ratio measures the percentage of sales revenue after deducting the cost of sales, operating expenses, and taxes. It is computed by dividing net profit by total revenue, as follows:
Net Profit Margin =Net Income / Revenue
A high net profit margin signifies that a company generates a substantial profit after all expenses are accounted for. Conversely, a low net profit margin may mean a company faces high costs or competitive pressures that limit its profitability. The ideal net profit margin also varies depending on the industry and the business’s size and maturity. Generally, a 10% or higher net profit margin is considered good for most companies, as it indicates that the business can generate a reasonable profit on its sales revenue.
Return on Equity
This ratio measures the return on investment for the business’s owners. It is derived by dividing net income by total equity.
Return on Equity = Net Income / Shareholders’ Equity
A higher return on Equity indicates that the business is generating a higher return on the investment made by its owners. This return should also be higher than the cost of borrowing money for shareholders to be adequately compensated for investing in the business.
The ideal return on Equity varies depending on the industry and the business’s growth potential. Generally, a return on Equity of 15% or higher is considered good for most companies, as it indicates that the business can generate a strong return on the investment made by its owners.
Uses of Financial Ratios
- Financial Analysis. Financial ratios are essential for analyzing a company’s financial statements and evaluating its financial health. By analyzing profitability, liquidity, and solvency ratios, stakeholders can gain insights into a company’s financial performance and make informed decisions about investments and operations.
- Forecasting. Financial ratios can also be used to forecast a company’s future financial performance. By analyzing trends in financial ratios over time, stakeholders can predict future financial performance and adjust their investment and management strategies accordingly.
- Benchmarking. Financial ratios can also be utilized to compare a company’s financial performance against industry standards or competitors. This can help businesses identify areas to improve and develop strategies to achieve better financial performance.
However, it’s important to note that these ratios can vary depending on the specific characteristics of each company and the industry in which it operates. Therefore, business owners should use benchmark ratios as a guide rather than an absolute measure of success or failure.
Limitations of Financial Ratios
- Limited Scope. Financial ratios are based solely on financial statements. They do not consider other factors impacting a company’s financial health, such as industry trends, market conditions, and management decisions.
- Industry Differences. Different industries and companies may have other benchmarks for a healthy ratio. Therefore, it’s vital to compare ratios within the same industry or sector.
- Historical Data. Financial ratios are based on historical data and may not accurately predict future performance. For example, changes in market conditions, industry trends, and company management can impact future financial performance and may not be reflected in historical financial ratios.
Financial ratios provide valuable insights into a company’s financial performance and help business owners and entrepreneurs make better decisions. By computing and interpreting these ratios, business owners can identify areas where they may need to make changes or improvements, as well as compare the financial performance over time and make informed decisions about the direction of the business.
However, it’s essential to be aware of their limitations and use them as part of a comprehensive analysis that considers other factors and relevant information that may impact a company’s financial performance.
As part of our financial modelling process, we conduct a ratio analysis.