Which of the following ratios measures the proportion of sales that finds its way into profits?

It’s hard to take steps to support the growth of your company without first knowing how your organization stacks up to the competition. If you’re looking to assess the health of your company and identify opportunities for improvement, take a look at your company financial ratios. These can be useful indicators of how well your company is performing in a number of financial areas.

Financial ratios are calculated from information derived from your company’s financial statements. This includes your cash flow statement, balance sheet, and profit and loss (P&L) statement. Before you start calculating your company’s financial ratios, take a moment to gather relevant documents.

Why is financial ratio analysis important?

Analyzing your company’s financial ratios can provide you with valuable insights into profitability, liquidity, efficiency and more. These ratios can help you visualize how your company has performed over a given period of time. You can also compare your company’s financial ratios with industry averages to see how you compare to other businesses in your sector.

Financial ratios may also be used by investors to determine the health of a business. If your company is publicly traded, it’s a good idea to monitor key financial ratios, as these numbers can impact how investors view your company. By understanding the factors that affect these ratios, you can take steps to produce results that will be more attractive to investors.

Important financial ratios for companies

There are a number of different financial ratios that can be calculated, measured and monitored. Typically, ratios are not examined alone, but are looked at in combination with other performance indicators. Below, we cover some key financial ratios used to assess business performance.

Cash flow ratios

Cash flow is important for every business. Ratios that examine cash flow can help you determine the current state of your assets and identify areas in which the cash flow cycle can be accelerated.

Current ratio

Current assets / Current liabilities

The current ratio examines your company’s ability to pay off liabilities with your current assets. The value of your total assets and liabilities can be obtained from your balance sheet. The higher your current ratio is, the more likely you will be able to pay off your financial obligations in the near future.

Quick ratio

Current assets – inventory / Current liabilities

Also known as the acid test ratio or cash ratio, the quick ratio is a good indicator of your company’s short-term liquidity. It tells you how many times liquid assets could be used to pay down your debt. Unlike the current ratio, the quick ratio disregards assets that cannot be easily converted into cash (such as inventory). If your quick ratio is between 1.5 and 2.0, this is usually considered healthy.

Accounts receivable days (AR days)

Accounts receivable / Net sales x 365

Receivables management is a vital component of ensuring strong cash flow. Accounts receivable days—sometimes referred to as days sales outstanding (DSO)—indicates how many days on average it takes to collect payments from your customers or clients. The ideal number of AR days differs from one industry to the next, but 45 days is usually considered to be a good number to shoot for. Higher numbers may indicate future cash flow problems.

You can adjust the time frame of this ratio by using data from a specific date range and changing the number of days as needed. If you’ve been taking steps to improve your cash flow and want to check if any progress has been made, it may be wise to calculate AR days quarterly or even monthly.

Leverage ratios

Leverage ratios measure a company’s debt compared to other financial metrics, such as equity or assets. They can help financial institutions estimate a company’s ability to pay back long-term debt. Below are some of the most commonly used leverage ratios.

Debt-to-equity

Total debt / Equity

Growth is an admirable goal, but businesses who take on numerous high-interest loans to achieve this growth might end up in hot water once it comes time to make payments. The debt-to-equity ratio will help gauge your company’s debt capacity—in other words, it can help you determine whether or not you can safely assume additional debt. Lenders typically look for a debt-to-equity ratio of 2-to-1 or less when analyzing business loan requests.

Debt-to-asset

Total debt / Assets

The debt-to-asset ratio shows how the value of your company’s assets compares to your total debt. A higher debt-to-asset ratio can be viewed as a sign of financial insecurity, as it indicates that a significant portion of your overall assets comes from liabilities such as commercial loans.

Interest coverage ratio

Operating income / Interest expenses

While debt-to-equity and debt-to-asset ratios are meant to show your company’s ability to pay off debt, the interest coverage ratio focuses specifically on how much interest your company owes on its outstanding debt. It’s calculated by dividing your earnings by your interest payments due within a given time period. This type of ratio is also referred to as the times interest earned ratio.

>>Related Reading: 5 Common Reasons Small Business Loans Are Denied (and How to Avoid Them)

Profitability ratios

Profitability ratios are used to measure how much income a company is able to generate after accounting for factors such as operating costs, taxes and debt payments. These ratios are crucial for business owners as well as potential investors who may be researching your company.

Gross profit margin

Net sales - cost of goods sold / Net sales

How much money is your company making as a percentage of sales? To find your gross profit margin, you subtract the cost of goods sold from your net sales amount, then divide this number by net sales. You’ll end up with a percentage that shows you how your profits compare to the cost of producing goods.

Operating profit margin

Operating income / Net sales

Unlike gross profit margin, operating profit margin takes into account your expenses. To calculate your operating profit margin, you take your operating income and divide it by your net sales for the period. This can give you a more realistic look of your company’s profitability.

Earnings before interest, taxes, depreciation and amortization (EBITDA) margin

EBITDA / Net sales

Your EBITDA margin is a key measurement that investors and potential acquirers look at, since it offers the truest picture of your company’s profitability. EBITDA shows what your company’s net profits look like before factoring in details such as interest, taxes and depreciation. This number is then divided by your net sales to determine your EBITDA margin.

Which financial ratios should you measure?

With so many financial ratios out there, it can be difficult to know which ones you should frequently calculate and monitor. Ultimately, you should focus on areas of your business that are currently of the highest priority to your treasury department and executive suite.

For example, if you’re about to start a new project that will require substantial funding, you may want to focus on reducing your existing debt-to-equity ratio before taking out an additional commercial loan. If your organization is having trouble meeting its monthly expenses, cash flow ratios can help you uncover opportunities to strengthen cash flow and improve your accounts receivable processes.

Alternatively, if your organization is in a good financial position and is primarily focused on finding ways to support growth and attract investors, then profitability ratios may be the most important types of ratios to monitor.

Benchmark your most important financial ratios

Keep in mind that financial ratios in and of themselves may not always be useful. Company financial ratios should be compared against prior performance periods or industry averages to see if financial performance is improving or declining. This type of analysis can also show you how you stack up against the competition.

For more information on how financial ratios can be used to support your business, contact a Cadence Bank Treasury Officer. Cadence Bank offers a range of treasury management services designed to help you improve the efficiency and profitability of your company. Our solutions include:

Reach out today to learn more. Or, download our free eBook, “Increase Efficiency With Integrated Treasury Management Solutions,” to see what type of benefits integrated treasury management could have for your company.

This article is provided as a free service to you and is for general informational purposes only. Cadence Bank makes no representations or warranties as to the accuracy, completeness or timeliness of the content in the article. The article is not intended to provide legal, accounting or tax advice and should not be relied upon for such purposes.

A common use of financial ratios is when a lender determines the stability and health of your business by looking at your balance sheet. The balance sheet provides a portrait of what your company owns or is owed (assets) and what it owes (liabilities). Bankers will often make financial ratios a part of your business loan agreement. For instance, you may have to keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities.

But ratios should not be evaluated only when visiting your banker. Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company. Although there are different terms for different ratios, they fall into 4 basic categories.

Liquidity ratios

These measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts, and provide a broad overview of your financial health.

The current ratio measures your company's ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it is calculated by dividing your current assets—such as cash, inventory and receivables—by your current liabilities, such as line of credit balance, payables and current portion of long-term debts.

The quick ratio measures your ability to access cash quickly to support immediate demands. Also known as the acid test, the quick ratio divides current assets (excluding inventory) by current liabilities (excluding current portion of long-term debts). A ratio of 1.0 or greater is generally acceptable, but this can vary depending on your industry.

A comparatively low ratio can mean that your company might have difficulty meeting your obligations and may not be able to take advantage of opportunities that require quick cash. Paying off your liabilities can improve this ratio; you may want to delay purchases or consider long-term borrowing to repay short-term debt. You may also want to review your credit policies with clients and possibly adjust them to collect receivables more quickly.

A higher ratio may mean that your capital is being underutilized and could prompt you to invest more of your capital in projects that drive growth, such as innovation, product or service development, R&D or international marketing.

But what constitutes a healthy ratio varies from industry to industry. For example, a clothing store will have goods that quickly lose value because of changing fashion trends. Still, these goods are easily liquidated and have high turnover. As a result, small amounts of money continuously come in and go out, and in a worst-case scenario liquidation is relatively simple. This company could easily function with a current ratio close to 1.0.

On the other hand, an airplane manufacturer has high-value, non-perishable assets such as work-in-progress inventory, as well as extended receivable terms. Businesses like these need carefully planned payment terms with customers; the current ratio should be much higher to allow for coverage of short-term liabilities.

Efficiency ratios

Often measured over a 3- to 5-year period, these give additional insight into areas of your business such as collections, cash flow and operational results.

Inventory turnover looks at how long it takes for inventory to be sold and replaced during the year. It is calculated by dividing total purchases by average inventory in a given period. For most inventory-reliant companies, this can be a make-or-break factor for success. After all, the longer the inventory sits on your shelves, the more it costs.

Assessing your inventory turnover is important because gross profit is earned each time such turnover occurs. This ratio can enable you to see where you might improve your buying practices and inventory management. For example, you could analyze your purchasing patterns as well as your clients to determine ways to minimize the amount of inventory on hand. You might want to turn some of the obsolete inventory into cash by selling it off at a discount to specific clients. This ratio can also help you see if your levels are too low and you're missing out on sales opportunities.

Inventory to net working capital ratio can determine if you have too much of your working capital tied up in inventory. It is calculated by dividing inventory by total current assets. In general, the lower the ratio, the better. Improving this ratio will allow you to invest more working capital in growth-driven projects such as export development, R&D and marketing.

Evaluating inventory ratios depends a great deal on your industry and the quality of your inventory. Ask yourself: Are your goods seasonal (such as ski equipment), perishable (food) or prone to becoming obsolete (fashion)? Depending on the answer, these ratios will vary a great deal. Still, regardless of the industry, inventory ratios can you help you improve your business efficiency.

Average collection period looks at the average number of days customers take to pay for your products or services. It is calculated by dividing receivables by total sales and multiplying by 365. To improve how quickly you collect payments, you may want to establish clearer credit policies and set collection procedures. For example, to encourage your clients to pay on time, you can give them incentives or discounts. You should also compare your policies to those of your industry to ensure you remain competitive.

Profitability ratios

These ratios are used not only to evaluate the financial viability of your business, but are essential in comparing your business to others in your industry. You can also look for trends in your company by comparing the ratios over a certain number of years.

Net profit margin measures how much a company earns (usually after taxes) relative to its sales. A company with a higher profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities.

Operating profit margin, also known as coverage ratio, measures earnings before interest and taxes. The results can be quite different from the net profit margin due to the impact of interest and tax expenses. By analyzing this margin, you can better assess your ability to expand your business through additional debt or other investments.

Return on assets (ROA) ratio tells how well management is utilizing the company's various resources (assets). It is calculated by dividing net profit (before taxes) by total assets. The number will vary widely across different industries. Capital-intensive industries such as railways will yield a low return on assets, since they need expensive infrastructure to do business. Service-based operations such as consulting firms will have a high ROA, as they require minimal hard assets to operate.

Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. It tells the shareholders how much the company is earning for each of their invested dollars. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%.

A common analysis tool for profitability ratios is cross-sectional analysis, which compares ratios of several companies from the same industry. For instance, your business may have experienced a downturn in its net profit margin of 10% over the last 3 years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is performing relatively well. Nonetheless, you will still need to analyze the underlying data to establish the cause of the downturn and create solutions for improvement.

Leverage ratios

These ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business.

Debt-to-equity and debt-to-asset ratios are used by bankers to see how your assets are financed, whether it comes from creditors or your own investments, for example. In general, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities.

Accessing and calculating ratios

To determine your ratios, you can use a variety of online tools such as BDC's ratio calculators, although your financial advisor, accountant and banker may already have the most currently used ratios on hand.

For a fee, industry-standard data is available from a variety of sources, both printed and online, including Dun & Bradstreet's Industry Norms and Key Business Ratios, RMA's Annual Statement Studies and Statistics Canada (search for Financial Performance Indicators for Canadian Business). Industry Canada's SME Benchmarking Tool offers basic financial ratios by industry, based on Statistics Canada small business profiles.

Interpreting your ratios

Ratios will vary from industry to industry and over time. Interpreting them requires knowledge of your business, your industry and the reasons for fluctuations. In this light, BDC experts offer sound advice, which can help you interpret and improve your financial performance.

Beyond the numbers

It's important to keep in mind that ratios are only one way to determine your financial performance. Beyond what industry a company is in, location can also be important. Regional differences in factors such as labor or shipping costs may also affect the result and the significance of a ratio. Sound financial analysis always entails closely examining the data used to establish the ratios as well as assessing the circumstances that generated the results.