Financial ratio analysis is the process of planning your business performance through proper financial management. Allso, businesses apply ratio analysis as a management tool to help determine its financial performance in the market by understanding its growth trend. Managers use financial ratio analysis as a key indicator of the strengths and weaknesses of their organizations thus developing strategies that are more effective.
When an investor or business individual wishes to fund your organization, he/she may use the financial ratio analysis to compare your performance against that of other related organizations. Basically, he/she will be able to determine how effective your financial management strategies are and the impact of your mission.
4 Main Components of the Financial Ratio Analysis
1. Solvency Ratios
You can also term these ratios may as liquidity ratios. Typically, businesses use them to determine the current assets and current liabilities available. Generally, a balance sheet is able to help know the capability of the business to pay its short-term debts.
Solvency ratios include:
- Current ratio: This helps you know how capable you are of meeting the short-term liabilities with the short-term assets. It uses the formula: Current assets/ Current liabilities;
- Adequacy of resources: This helps you know how long your company can survive without receiving any further funds. You can obtain this through the formula: (Cash + Marketable securities + Accounts receivable)/ Monthly expenses;
- Quick ratio: You use this formula if you want to know whether your company is liquid enough to meet the urgent liabilities. It relies upon the formula: (Cash +AR + Marketable securities) / Current liabilities;
- Working capital: This is a common financial ratio analysis and it is in use to help assess the cash flow in the business. It uses this formula: Current assets – Current liabilities.
2. Profitability Sustainability Ratios
These help determine the performance of a business over time and you can use the following ratios:
- Return of equity ratio: This is used to calculate the actual return on investment by the investors with the aim of analyzing the organization’s performance. It is based on the equation: Net profit/ Average shareholder equity;
- Sales growth ratio: You use this financial ratio analysis to determine the increase or decrease of sales between two consecutive periods. Its formula is: (Current period –Previous period sales) /Previous period sales;
- Reliance on Revenue source: This ratio is used by businesses to measure the contributions made by various sources. This helps determine what revenue source can be relied upon and which source is unreliable. It is calculated using the following formula: Revenue source total revenue/ Total revenue;
- Operating self-sufficiency: If you are looking to know how well your organization can finance itself and meet its expenses without having to rely on grants, then this is the right ratio to use. You will use the formula below: Business revenue/ Total expenses. The total business revenue figure should be exclusive of the non-operating revenue as well as all contributions.
Other Ratios and What They Determine
- Gross profit margin: It is an important financial ratio analysis as it can determine the profitability level of your organization. If the margin is small, then it means that your ability to make profits is low and this is a major weakness in a company. Calculating this ratio requires this formula: Gross profit/ Total sales. This does not include the indirect costs.
- Net profit: This financial ratio helps businesses know what profit they make for every sale made. Unlike the previous ratio, you will use this this to determine your ability to cover all the operating costs that include the indirect costs. This is the formula to use: Net profit/ Sales;
- SGA to sales ratio: SGA stands for sales, general, and admin. This ratio can calculate the percentage of the indirect cost to the sales. When you obtain a ratio that is decreasing or is steady, you know that you are in control of the overhead. You will use the following formula: Indirect Costs (sales, general, admin)/ Sales;
- Return on assets: You can calculate this ratio using the formula: Net profit average/ Total assets. Organizations use it as a way of assessing their ability to turn assets into profits. It relies on your ability to manage and invest in your assets efficiently.
3. Operational Efficiency Ratios
Businesses apply these financial ratio analysis when they need to learn how well they manage the liabilities and exploit their assets. The different ratios in use for this purpose include:
- Operating expense ratio: This ratio is able to compare an organization’s expenses to the revenue. If the ratio is decreasing, it means that the business is operating efficiently. It uses the formula: Operating expenses/ Total revenue;
- Accounts receivable turnover: A company will opt for this ratio if its management wishes to determine the number of times its accounts receivables turnover annually. It relies on the formula: Net sales/ Average accounts receivable;
- Inventory turnover: Organizations use this ratio to determine the number of days taken before the selling of the inventory. This helps in planning production and the proper control of various business activities. It uses the formula: Cost of sales/ Average inventory;
- Accounts payable turnover: This determines the number of times the accounts payable are made per year. It’s basically the period between making a purchase and paying for them. You use the formula: Cost of sales/ Average accounts payable;
- Total asset turnover: This ratio is in use to calculate the sales generated for every dollar of assets. This helps determine whether the business is using its assets productively. This is the formula you ought to use: Revenue/ Average total assets.
4. Leverage Ratios
These ratios allow organizations to estimate to what extent they are able to use or exploit the borrowed money and what level of risks they face. There are only two ratios that you can use for this purpose and they are:
- Interest coverage ratio: This ratio answers the question how well are you able to pay off the interest payments levied on the business through its income. Moreover, an ideal interest coverage ratio should be 1.5. You can obtain it through the formula: EBITDA interest/ Expense;
- Debt to equity: This ratio can compare the capital that organization owners contribute with versus the borrowed funds. So, you can calculate it using the formula: (Short term debt + Long term debt)/ Total equity (including grants).
Financial ratio analysis is an essential concept in the commercial industry. This is because it helps businesses to keep tabs of their financial performance. Also, in return, the values you can obtain from these ratios can plan for a better performance through better financial management or planning strategies.
The above ratios are some of the specific ratios that you should include in the financial ratio analysis process. However, organizations may customize ratios tailored specifically for their operations and financial trends. Now you know what to expect whenever you hear of financial ratio analysis and how you can approach the concept.