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.
Ratios can indicate whether a business is sufficiently profitable or whether cash flow is adequate to meet financial obligations.
The following are the main financial ratios to measure the financial health of a business.
Leverage ratios
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.
Liquidity ratios
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. Cash ratio • Current assets/Current liabilities
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.
Profitability ratios
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.
Operations ratios
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.