Financial ratios are quantitative measures used to assess the performance and overall financial health of a business. The end goal of using ratio analysis is to improve the decision making process. Ratio analysis not only compares similar businesses to each other, but can also be used to track a business’s performance from year to year.
In this article, I categorize financial ratios into five categories: profitability, leverage, liquidity, efficiency, and growth.
Profitability ratios are financial measures used to measure and assess a company’s ability to generate profit relative to revenues, assets, operating costs, and equity over a given time period. They show how much a company uses its assets to generate profits and value for its shareholders. Profitability ratios fall into two categories: yield ratios and margin ratios.
Performance ratios represent the company’s ability to generate returns for its shareholders. These ratios typically compare a measure of performance to certain items on the balance sheet: return on equity and return on assets. These are used to measure how much capital is deployed in a business. For example, if the business only generates a 3% return for the owner, would the capital be better used elsewhere, such as the stock market?
Margin ratios measure how well the business converts sales into profits to varying degrees of measure. Margin ratios look at returns versus top earnings. Typically, it compares the following items in the income statement (income statement): gross margin, operating profit margin, and net profit margin. Margin ratios show operational consistency from year to year. If gross margins decline, for example, can the company find a cheaper supplier for its products or pass the costs on to customers?
Leverage ratios represent the extent to which a business uses borrowed money. These ratios indicate the level of indebtedness incurred by a business entity in relation to other accounts on its balance sheet, income statement or statement of cash flows.
The debt ratio is a total measure of the coverage of debt (short and long term) against the owner’s equity in the business. Lenders may be concerned if total liabilities exceed equity.
Interest coverage shows the company’s ability to at least pay its interest expense. It is generally calculated as EBITDA (earnings before interest, taxes, depreciation and amortization) divided by interest expense. Lenders expect a ratio greater than 1.0.
Liquidity ratios are closely related to leverage ratios. They are used to assess the financial strength of a business. These ratios measure a company’s ability to repay its debts in the short and long term. The two most common ratios are the current ratio and the quick ratio.
The current ratio is calculated by dividing current assets by current liabilities. The ratio indicates the extent to which available liquidity and available assets are sufficient to repay short-term debts.
The quick ratio is applied as a more stringent test and is calculated as cash plus accounts receivable divided by current liabilities, indicating the cash available to cover current liabilities. It is also known as the acid ratio.
Efficiency ratios are used to measure how well a business is using its assets and resources. These ratios look at how many times a business can accomplish a measure in a certain amount of time, or how long it takes a business to complete segments of its operations. For example, the inventory turnover rate shows how many times a company can sell an entire inventory of inventory in a given time period. Typical ratios in this group are inventory turnover, number of days outstanding sales, and fixed asset turnover. I’ve discussed the cash conversion cycle before (KBJ October 30, 2020) as an example of how efficiently a business turns inventory and sales into cash.
We use growth ratios to assess the company’s performance in terms of revenue and profitability over one or more time periods. To measure one-year profitability, we take the 2020 end-of-year profit and divide by the 2019 end-of-year profit then subtract one:
Profit 2020 Profit 2019 – 1 is the percentage change in profitability over one year.
For several years, we use a geometric calculation. For example, if we wanted to see the annual percentage of profitability over five years from 2016 to 2020, for example, we would use this formula:
Profit 2020 Profit 2016 ^ 14 – 1 equals compound annual growth.
Benchmarking allows us to make sense of the ratios we have calculated. We may use internal measures of company performance from year to year or we may use industry statistics provided by BizMiner or Risk Management Associates.
Ratio analysis provides valuable information to help make decisions and provide quantitative information on how the business is run. A ratio analysis worksheet is available for download from our website: centralpacval.com/ratios.
Kevin Lowther, AM-ASA, ABV, FMVA is a partner of Central Pacific Valuation, based in Bakersfield. It provides business valuation and financial analysis services.