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Of course, there are dozens—if not hundreds—of potential financial ratios to track. So which ones are most important for you? This article will help you decide.
Why are financial ratios important?
Financial ratios are important because they give business owners a way to evaluate financial performance beyond financial statements and compare it to similar businesses in their industry.
Your balance sheet, income statement, and cash flow statement are helpful, but they offer only limited insight. Financial ratios go beyond the numbers to reveal how efficiently your company is at funding itself, making a profit, growing through sales, and managing expenses. They can also provide a warning sign that things aren’t working, letting business owners and managers know when to make a change.
Most important financial ratios
There are dozens of financial ratios you can track, but the most important financial ratios fall into one of four broad categories:
- Liquidity
- Leverage
- Profitability
- Asset management
We’ll look at 10 ratios across these four categories and provide a detailed walkthrough for each.
Liquidity ratios
Liquidity is a measure of your business’s ability to cover its short-term obligations, such as accounts payable, accrued expenses, and short-term debt. When a company has liquidity troubles, it may have trouble paying employees and suppliers and covering other daily operating expenses, leading to big problems.
Liquidity ratios typically compare the company’s current assets (cash, inventory, and receivables) with current liabilities.
1. Current ratio
Your current ratio, also known as your working capital ratio, estimates your ability to pay short-term obligations—liabilities and debts due within one year.
Current Ratio = Current Assets / Current Liabilities
Ideally, your current ratio will be greater than one, meaning you can settle every dollar owed for payables, accrued expenses, and short-term debts with your existing current assets.
2. Quick ratio
Your quick ratio, also known as your acid test ratio, is similar to current ratio in that it’s a gauge of your business’s ability to pay its debts. However, it looks at only the company’s most liquid assets (cash, marketable securities, and accounts receivables) rather than all current assets. It excludes prepaid expenses because you can’t use them to pay other short-term liabilities and excludes inventory because it could take too long to convert to cash.
Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
A quick ratio above 1 means your business has enough liquid assets to cover short-term obligations and maintain your operations.
3. Days of working capital
Days working capital indicates the number of days required to convert your working capital into sales.
Days Working Capital = ((Current Assets - Current Liabilities) x 365) / Revenue from Sales
A high days working capital number means that your company takes longer to realize cash from its working capital. Companies with lower days working capital have less need for financing because they make efficient use of working capital.
The best way to evaluate your result is to compare it with those of other companies within the same industry.
Leverage ratios
Leverage is the amount of debt your company has in its capital structure, which includes both debt and shareholders’ equity. A company with more debt than average for its industry is considered highly leveraged.
Being highly leveraged isn’t necessarily a bad thing. A growing company might take advantage of low interest rates to seize market opportunities. Being highly leveraged could be a smart business decision as long as the company can comfortably afford to make debt payments. However, companies that struggle to make debt payments may fall behind and not be able to borrow additional money to stay afloat.
4. Debt to equity ratio
Your debt to equity ratio compares total debt to total equity to measure the riskiness of the company’s financial structure. Lenders and other creditors closely monitor this metric, as it can provide an early warning sign when companies are taking on too much debt and may have trouble meeting payment obligations.
Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity
A good debt to equity ratio varies by industry. A ratio around 2 or 2.5 is generally considered good for most companies. That means that for every dollar shareholders invest in the company, about 66 cents comes from debt while the other 33 cents come from equity.
However, companies with consistent cash flows might be able to sustain a higher ratio without running into problems.
5. Debt to total assets
Your debt to total assets ratio tells you the percentage of your company’s assets financed by creditors.
Debt to Total Assets = Total Debt / Total Assets
Companies with high debt to total assets ratios are risky to invest in because the company has to pay out a higher percentage of its profits in principalle and interest payments than a similar-sized company with a lower ratio.
Most investors prefer to put their money into companies with a debt to total assets ratio below 1. This shows the company has more assets than liabilities and could pay off its debts by selling assets if needed.
Profitability ratios
Profitability ratios evaluate your ability to generate income (profit) and create value for shareholders.
6. Profit margin
Your net profit margin ratio measures the amount of net income earned with each dollar of sales generated by the company. In other words, it shows what percentage of sales is left over after paying all business expenses.
Profit Margin Ratio = Net Income / Net Sales
A good profit margin ratio varies by industry, so it’s helpful to benchmark your results against your competitors using a database of profit margins by sector, like this one from the NYU Stern School of Business.
7. Return on assets
Return on assets (ROA) indicates how well your company is performing by comparing your profits to the capital you’ve invested in assets. The higher the ROA, the more efficiently you use your economic resources.
Return on Assets = Net Income / Average Total Assets
While comparing your ROA to other companies in your industry is helpful, it’s more helpful to look at how your return on assets changes over time. If this metric rises from year to year, it generally indicates that you’re squeezing more profits out of each dollar of assets on the balance sheet. However, if your ROA is declining, it could mean you’ve made some bad investments.
8. Return on equity
Your return on equity (ROE) measures the company’s ability to generate profits from shareholder investments into the business.
Return on Equity = Net Income / Shareholders’ Equity
A good ROE depends on your industry. For example, according to the NYU Stern School of Business, the ROE for electronics companies averages around 44%, while engineering and construction companies average just above 6%.
Asset management ratios
Asset management ratios analyze how efficiently a company uses its assets to generate sales. The following ratios are normally only used by businesses that carry inventory or sell to customers on credit.
9. Inventory turnover
Your inventory turnover ratio measures how efficiently you manage inventory.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
When evaluating your inventory turnover ratio, compare your metric to companies operating in the same industry. A low inventory turnover ratio compared to the industry average can indicate that your sales are poor or you’re carrying too much inventory.
10. Receivables turnover
Receivables turnover measures how quickly you collect sales made on credit.
Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable
Determining whether your receivables turnover ratio is good or bad involves comparing your metrics to your company’s credit policies and payment terms. For example, if your credit terms allow customers to pay invoices within 30 calendar days but your receivables turnover shows that it’s averaging 45 days to collect payments, you may have a problem with extending credit to customers who aren’t able to pay or need to tighten up your collection processes.
On the other hand, if you have a Net 60 policy, collecting payments within 45 days means you’re exceeding your goals.
How Bench can help
These key financial ratios are essential analysis tools that business owners can use to quickly evaluate your company’s profitability and performance. By tracking these metrics over time, you can spot risks before they become problems and make changes to improve your bottom line.
Of course, it all starts with solid bookkeeping. Bench helps you stay on top of your company’s performance by giving you all the information you need to calculate important financial ratios.
Each month, your transactions are automatically imported into our platform and categorized and reviewed by your personal bookkeeper. Explore our platform with a free tour today.
Further reading: How to Calculate and Use Year-over-Year (YoY) Growth
