Financial Ratios

9 Financial Ratios to Know

Once you have your balance sheet and income statement, you can start analyzing your company’s financial health by using several financial ratios.

Profitability Ratios

Profitability ratios show your potential investors how well your company converts core business operations into profits.

Return on Assets

Return on assets (ROA) indicates how well your company uses its assets to make money.

If your company had a net income of $5,000 and owns $50,000 in assets, your ROA is 10%, so for every $1 you own in assets, you make a $0.10 profit.

The higher your ROA, the better.

Return on Equity

Return on Equity (ROE) indicates your company’s ability to reward investors.Return on Assets

If your company had a net income of $5,000, and your investors have $50,000 in equity, your ROE is 10% – for every $1 of equity, your company generates $0.10 in profits. Like ROA, the higher your ROE, the better.

Profit Margin

Your profit margin indicates how much of your company’s total sales flow through your bottom line.

If you reported a net income of $5,000, and had a total revenue of $20,000, your profit margin is 25%. A high profit margin is good for you and your investors.

Liquidity Ratios

Liquidity ratios show investors whether you’re capable of meeting short-term debt obligations.

Current Ratio

The current ratio indicates your business’s ability to pay your short-term obligations, using short-term assets.

If you have $30,000 in current assets and $25,000 in current liabilities, your current ratio would be 1.2

When your current ratio is over 1.0, you have more current assets than current liabilities and should not have any issues paying your current liabilities, if they become due. If your current ratio is less than 1.0, you have more current liabilities than current assets and might run into problems if your liabilities become due.

Quick Ratio

Like your current ratio, your quick ratio measures how well your company can meet short-term obligations. Unlike your current ratio, your quick ratio doesn’t include inventory in your current assets because it assumes that it’ll take several weeks, or even months, to sell your inventory. The quick ratio only considers assets you can use today to pay your obligations.

If you have $30,000 in current assets, but $2,000 of that is in inventory, and $25,000 in current liabilities. Your quick ratio would be 1.12.

Like your current ratio, if your quick ratio is less than 1.0, you may run into trouble if your liabilities become due.

Debt Ratios

Debt ratios show investors your company’s ability to meet your long-term debt obligations.

Debt-Equity Ratio

Your debt-equity ratio looks at the relationship between capital you’ve borrowed and capital you’ve raised through investors.

If your company has $30,000 in liabilities and $50,000 in assets, your debt-equity ratio is 1.5.

A high debt-equity ratio usually means your company has borrowed more aggressively, which means your company is a higher risk for new investors. A low debt-equity ratio signifies that your company is less of a risk. You’ll have to research typical debt-equity ratios in your industry to determine what’s a high or low ratio.

Interest Coverage Ratio

Your interest coverage ratio measures whether your company can meet its interest payment obligations.

You can determine your earnings before interest and tax (EBIT) by subtracting your expenses from your sales revenue.

If your sales revenue is $20,000 and your expenses are $5,000, your EBIT is $15,000. Your interest coverage ratio is 1.5, if your interest expense is $10,000.

If your interest coverage ratio is less than 1.0, your company might be in trouble. If you can’t meet your interest obligations, you might be forced into bankruptcy.

Efficiency Ratios

Efficiency ratios show how well your business is using its resources and working capital.

Asset Turnover Ratio

The asset turnover ratio measures how well you’re using your assets to make your products.

If your sales are $30,000 and your assets are $15,000, your asset turnover ratio is 2. This means that for every $1 you own in assets, you generate $2 in sales.

Inventory Turnover Ratio

The inventory turnover ratio measures how fast your company sells inventory. You should try to sell your inventory as fast as possible.

If your sales are $20,000 and your inventory is $5,000, your inventory turnover ratio is 4. The higher the ratio, the more quickly you’re selling and moving your inventory.