Financial ratios are metrics that help measure the health and performance of a business. Such ratios help tell the story behind what’s disclosed in the company’s financial statements, and they are relevant for both small and large businesses. They are also referred to as Key Performance Indicators (KPIs).
Financial ratios are calculated based on information contained within the company’s financial statements. Once calculated, a particular ratio is put to use by making the following comparisons:
- With one’s own business in a prior period (actual and budget/business plan).
- With one’s own business in the current period (actual and budget/business plan).
- With another business (same industry / same approximate size) in a prior period.
- With another business (same industry / same approximate size) in the current period.
Besides helping you evaluate the health of a company, financial ratios can identify, through the use of trend analysis, potential problems in the realms of profitability, liquidity, return on equity, going concern, potential bankruptcy, solvency, etc.
On the other hand, the use of ratios can help identify “winning combinations” that the business owner never even considered.
Main Categories of Financial Ratios
Liquidity Measurement Ratios
Profitability Indicator Ratios
Operating Performance Ratios
Cash Flow Indicator Ratios
Investment Valuation Ratios
Additional Financial Ratios (KPI’s) Widely Used By Small Businesses
Source. Tax Prep for Artists
Financial Ratio Example – Current Ratio
Current Ratio = Current Assets / Current Liabilities
The Current Ratio is a widely used metric for evaluating short-term liquidity. It provides a “snapshot” of the company’s ability to pay its bills that are coming due in the short-term. If the metric is a positive value equal to or greater than 1, then it would appear the company can pay its bills.
On the other hand, if the metric is a negative value equal to or less than 1, then the company may encounter difficulty in paying its bills and could conceivably go bankrupt.
Financial Ratio Example – Cash Ratio
Cash Ratio = Cash + Cash Equivalents / Current Liabilities
Somewhat similar to the Current Ratio is the Cash Ratio. The only difference between the two ratios is that the Cash Ratio omits from the numerator all components of current assets other than cash and cash equivalents. “Cash” is immediately available for paying. “Cash Equivalents” are assets that can more easily be converted into cash in the short-term, and are more liquid than other non-cash assets.
As in the case with the Current Ratio, if the metric is a positive value greater than or equal to 1 then the company should be able to pay its bills. On the other hand, if the metric is a negative value less than or equal to 1 then the company may be in trouble.
Financial Ratio Example – Debt Ratio
Debt Ratio = Total Liabilities / Total Assets
The Debt Ratio is an indicator of a company’s overall solvency. If the debt ratio is greater than 1, the company has more debts than it’s able to pay off and its ability to continue as a going concern is brought into question. On the other hand, if the ratio is a value less than 1, then it’s assumed the company is solvent and able to pay off all of its debts from the assets it has on hand.
Financial Ratio Example – Gross Profit Ratio
Gross Profit Ratio = Gross Profit / Net Sales
This ratio is customarily used to evaluate profitability. It looks at how much profit resides in each dollar’s worth of net sales. In other words, how profitable are the company’s net sales dollars? As the gross profit ratio gets lower, the amount of profit realized from each dollar’s worth of net sales also lowers. The closer the gross profit ratio is to 1, the more profitable net sales are assumed to be.
Therefore, “Net Sales” are by definition gross sales dollars less items such as discounts, returns, and refunds. Gross Profit is calculated by subtracting cost of sales from total revenue.
KPI’s Other Than Financial Ratios
So far, the discussion has centered on financial ratios that comprise what the world has come to know as Key Performance Indicators (“KPIs”). However, there are indeed some very relevant “non-financial ratio” metrics that can shed some light on factors and issues affecting the performance of the company. It is a mistake to ignore and underestimate the existence and importance of these metrics.
Let’s first look at “employee turnover,” or employee satisfaction, as an example of a KPI that is not a financial ratio. A significant part of the success of a company is dependent on a stable work force. The facts already show that an unstable work force has a negative impact on performance because there is a cost associated with hiring and retaining qualified personnel.
If the work place has a high rate of turnover then something is definitely wrong and needs to be looked into -- be it widespread dissatisfaction with management, compensation, benefits, etc. High turnover also needs to be addressed because the business plan likely assumes that matters such as high turnover are a “non-issue.”
Customer service is another relevant KPI that is crucial to a company’s success story. There is no company and there is no business to be had unless the company has customers who are satisfied and keep coming back. The business plan likely assumes that there is not even a little problem with customer dissatisfaction. There is no easy off-the-shelf formula to begin evaluating and fixing a problem with customer dissatisfaction.
Management Needs to Systematically Review Non-Financial Ratio Factors
The point is that management needs to develop a system of its own KPI metrics and maintain a systematic program of review that gives attention to the non-financial ratio factors such as customer satisfaction that is geared to the particular company at hand.
An effective system for measuring KPI is useful to all functional areas and departments within the organization. KPIs aren’t just related to the accounting/number crunching/financial statement -- i.e. “paper pushing” -- people. When we talk about the need for KPIs, what we’re really saying is that a successful company will benefit from having KPIs for all departmental teams such as Sales, Marketing, Purchasing, Human Resources, Accounting, Accounts Receivable, Accounts Payable, Call Center, Advertising, Help Desk, etc. -- the list goes on.
The bottom-line: the better system you have in place for measuring all manner of KPIs, the better chance you have for success.