By Kimberlee Leonard Updated December 20, 2018
There are dozens of financial ratios and their meanings help business owners evaluate the financial health of a company. Financial ratios can be broken into six key areas of analysis: liquidity, profitability, debt, operating performance, cash flow and investment valuation. Interpreting financial ratios requires understanding income statements and balance sheets.
Financial Ratios Definitions
The ratios derived in financial reports for a company are used to establish comparisons either over time or in relation to other data in the report. A ratio takes one number and divides it into another number to determine a decimal that can later be converted to a percentage, if desired.
For example, a debt-to-equity ratio looks at the debt liabilities of the company and divides it by the asset equity. If a company has $200,000 in debt and $100,000 in equity, the debt-to-equity ratio is two ($200,000 / $100,000 = 2). This means the company has $1 dollar of equity for every $2 of debt. In this case, the larger the ratio over one is interpreted as an increasing debt problem that could lead to long-term financial problems for the company.
Key Financial Ratios
Evaluating the key financial indicators is something every business owner should become well versed in. By understanding what each key financial ratio is assessing, you can more easily derive the ratios with a quick look at the financial statements.
- Liquidity Measurement Ratios: These ratios define if a company is able to meet short-term financial obligations. It takes into consideration liquid assets to short-term liabilities.
- Profitability Indicator Ratios: These ratios consider the amount of profit derived from the cost of goods sold or the operating expenses. There are both gross and net profit margin ratios.
- Debt Ratios: Debt ratios are like the debt-to-equity ratio described above that consider how much debt a company has and the assets it possessesto pay debts off.
- Operating Performance Ratios: These ratios look at numbers like the fixed asset turnover or sales-to-revenue per employee numbers to determine efficiency. An efficient company generally improves profitability.
- Cash Flow Indicator Ratios: Companies need to generate enough cash flow to pay operating expenses, grow the business and create a safety net of retained earnings. Operating cash flow divided by sales ratio determines how much it costs to acquire new clients.
- Investment Valuation Ratios: These ratios help investorsdetermine the viability of existing or new investment into a company. For example, the price-to-earnings ratio provides the amount a company is paying per $1 of earnings to shareholders.
Companies large and small use ratios to evaluate internal trends in the company and define growth over time. While a publicly traded company may have much larger numbers, every business owner can use the same data to strategically plan for the next company fiscal cycle.
Financial Ratio Analysis and Interpretation
Analyzing and interpreting financial ratios is logical when you stop to think about what the numbers tell you. When it comes to debt, a company is financially stronger when there is less debt and more assets. Thus a ratio less than one is stronger than a ratio of 5. However, it may be strategically advantageous to take on debt during growth periods as long as it is controlled.
A cash flow margin ratio calculates how well a company can translate sales into actual cash. It is calculated by taking the operating cash flow and dividing it by net sales found on the income statement. The higher the operating cash flow ratio or percentage, the better.
The same is true with profit margin ratios. If it costs $20 to make a product and it is sold for $45, the gross profit margin is calculated by subtracting the cost of goods sold from revenue and dividing this result by the revenue [0.55 = ($45- $20) / $45]. The higher this ratio is, the more profit there is per product.
