K.M. FORSTER & CO.
Chartered Professional Accountant
Articles > How to use financial ratios to improve your business


31 Jan 2019

Financial ratios offer entrepreneurs a way to evaluate their company’s performance and compare it other similar businesses in their industry.
 
Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This allows you to follow your company’s performance over time and uncover signs of trouble.
 
Here are some key financial ratios to measure the financial health of your business.
 
Leverage ratios
 
Debt-to-equity ratio = Total liabilities / Shareholders' equity
 
Measures how much debt a business is carrying as compared to the amount invested by its owners. This indicator is closely watched by bankers as a measure of a business’s capacity to repay its debts.
 
Debt-to-asset ratio = Total liabilities / Total assets
 
Shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness.
 
Liquidity ratios
 
Working capital ratio = Current assets / Current liabilities
 
Indicates whether a business has sufficient cash flow to meet short-term obligations, take advantage of opportunities and attract favourable credit terms. A ratio of 1 or greater is considered acceptable for most businesses.
 
Cash ratio = Liquid assets / Current liabilities
 
Indicates a company's ability to pay immediate creditor demands, using its most liquid assets. It gives a snapshot of a business's ability to repay current obligations as it excludes inventory and prepaid items for which cash cannot be obtained immediately.
 
Profitability ratios
 
Net profit margin = After tax net profit / Net sales
 
Shows the net income generated by each dollar of sales. It measures the percentage of sales revenue retained by the company after operating expenses, interest and taxes have been paid.
 
Return on shareholders’ equity = Net income / Shareholders' equity
 
Indicates the amount of after-tax profit generated for each dollar of equity. A measure of the rate of return the shareholders received on their investment.
 
Coverage ratio = Profit before interest and taxes / Annual interest and bank charges
 
Measures a business's capacity to generate adequate income to repay interest on its debt.
 
Return on total assets = Income from operations / Average total assets
 
Measures the efficiency of assets in generating profit.
 
Operations ratios
 
Accounts receivable turnover = Net sales / Average accounts receivable
 
A higher turnover rate generally indicates less money is tied up in accounts receivable because customers are paying quickly.
 
Average collection period = Days in the period X Average accounts receivable / Total amount of net credit sales in period
 
Indicates the amount of time customers are taking to pay their bills.
 
Average days payable = Days in the period X Average accounts payable / Total amount of purchases on credit
 
Measures the average number of days it you are taking to pay suppliers.
 
Inventory turnover = Cost of goods sold / Average inventory
 
Indicates the number of times inventory has been turned over during the year.
 
 

BDC

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