How do you measure how robust your business is? One of the key ways is by looking at financial ratios, which can be grouped into four categories.
Liquidity — Your business’s ability to remain liquid so you can meet your short-term liabilities. How much of a cash cushion do you have each accounting period? How much of your operating cash flow is funneled into your spending projects? Here are some ratios to help with liquidity measurements
- Current ratio, which measures your ability to meet obligations due in less than one year.
- Defensive interval ratio, which compares assets to daily cash expenditures.
- Operating cash flow, which evaluates your ability to pay off short-term liabilities using cash flow from operations.
Operational risk — How much inherent risk there is in your capital structure and operating model. Operational risk will tell you about your creditworthiness and ability to meet periodic liabilities. This is useful in evaluating leverage. Here are some ratios to measure operational risk:
- Asset coverage ratio, which measures your ability to cover debt obligations with assets.
- Cash coverage ratio, which measures your ability to cover debt obligations with cash.
- Debt service coverage ratio, which evaluates your ability to use operating income to repay debt obligations, including interest.
Profitability — How much profit you can wring from your assets or equity, and how well you have used funds to develop a profitable operational model. Some profitability ratios include:
- Gross margin ratio, which is the revenue left over after the cost of goods sold is deducted.
- Net profit margin, which is the percentage of revenue left over after all expenses and taxes.
- Operating margin, which is the percentage of revenue left over after all expenses.
Efficiency — The capacity and turnover of your operations. Efficiency measurements identify areas for improvement. They include:
- Accounts payable turnover ratio, which expresses credit purchases as a multiple of accounts payable.
- Contribution margin ratio, which shows the percentage of earnings retained after variable costs.
- Employee turnover, which shows the percentage of employees who have left the company, voluntarily or involuntarily.
Other essential numbers
Also consider these key calculations:
- Return on assets quantifies how much profit the business has generated relative to its available assets.
- Return on equity quantifies how much profit is generated relative to available equity financing.
- Return on investment is a general return figure that investors use to quantify investment performance.
- Earnings per share measures net income earned on each share of stock.
- Price-earnings ratio reflects investors’ assessments of future earnings.
- Debt-equity ratio is calculated by adding outstanding long- and short-term debt and dividing it by the book value of shareholders’ equity.
With these ratios, financial performance can be ranked against time-series data, competitor ratios and performance targets. You can draw insights from how computed ratios have evolved over time, and you can benchmark your management against targets you set up for your company.
Financial ratios help you in deciphering the overall health of your business. Applying formulas helps you understand your own business and choose the best stocks for your portfolio. When combined, these ratios are used to get a complete picture of a company’s prospects.