Ratios measure the relationship between two or more figures in the financial statements. They are used most effectively when results over a number of periods or years are compared. You will see trends or inconsistencies that might need to be addressed.
The following are the main financial ratios to measure the financial health of a business.
1. 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 banks as a measure of a business’s capacity to repay its debts.
2. 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.
1. Working capital ratio • Current assets/Current liabilities
Indicates whether a business has enough cash flow to meet short-term obligations. A ratio of 1 or greater is considered acceptable for most businesses.
2.Indicates a company’s ability to pay immediate liabilities using its most liquid assets. Shows a business’s ability to repay current obligations as it excludes stock and prepaid items for which cash cannot be obtained quickly.
1. Net profit margin • After tax net profit/Net sales
Shows the net income generated by each € of sales. It measures the percentage of sales revenue retained by the company after expenses, interest and taxes have been paid.
2. Return on shareholders’ equity • Net income/Shareholders’ equity
Indicates the amount of after-tax profit generated for each € of equity. It is a measure of the rate of return the shareholders received on their investment.
3. 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.
4. Return on total assets • Income from operations/Average total assets
Measures the efficiency of assets in generating profit.
1. Accounts receivable turnover • Net sales/Average debtors
A higher turnover rate generally indicates less money is tied up in debtors because customers are paying quickly.
2. 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.
3. Average days payable • Days in the period X Average creditors/Total amount of purchases on credit
Indicates the average number of days a business takes to pay suppliers.
4. Stock turnover • Cost of goods sold/Average stock
Indicates the amount of times stock has been turned over during the year.