What are the four types of financial ratios?
Although there are many financial ratios businesses can use to measure their performance, they can be divided into four basic categories.
- Liquidity ratios
- Activity ratios (also called efficiency ratios)
- Profitability ratios
- Leverage ratios
Common ratios used to measure financial health
Liquidity
| Profitability
|
Activity
| Leverage
|
Liquidity ratios
Liquidity ratio provide a key warning system to a company, letting it know if it's running low on available funds. The ratios measure the amount of liquidity, namely cash and easily converted assets, for covering your debts, and provide a broad overview of your financial health.
These are the ratios to use when you want to know if you can pay your bills.
Examples of liquidity ratios
Current ratio
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 the current portion of long-term debts.
Current ratio formula
Current assets
Current liabilities
Quick ratio
The quick ratio, like the current ratio, measures your ability to access cash quickly to support immediate demands. However, the quick ratio excludes inventory. Also known as the acid test ratio, the quick ratio divides the inventory-excluded current assets by current liabilities (excluding the current portion of long-term debts).
Quick ratio formula
Quick assets (cash + accounts receivable + short - term investments)
Current liabilities
How to interpret liquidity ratios?
For both the quick ratio and the current ratio, a ratio of 1.0 or greater is generally acceptable, but this can vary depending on your industry.
A comparatively low current or quick ratio can mean that your company might have difficulty meeting its obligations and may not be able to take advantage of opportunities that require quick cash.
You can improve a low ratio by:
- paying off your liabilities
- delaying purchases
- collecting receivables more quickly
A higher ratio may mean that your capital is being underused 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.
Liquidity ratios vary by industry
What constitutes a healthy ratio depends on the industry in which your company operates.
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, which means the company could function with a current ratio close to 1.0.
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.
Activity ratios (efficiency ratios)
Activity ratios, also called efficiency ratios are used to measure a company's ability to convert their production into cash or income. Often measure over a three-to-five-year period, they provide insight into areas of your business such as collections, cash flow and operational results.
Examples of activity ratios
Average days inventory
Average days inventory indicates the average number of days it takes to sell your inventory. You can use this ratio to make sure you don’t over-order or let inventory collect dust from being held for too long.
In general, shorter average days inventory is preferable, as it implies your money is not tied up for long in the process of generating revenue.
Average days inventory formula
1. Calculate average inventory
Starting inventory balance + Ending inventory balance
2
2. Calculate average days inventory
Average inventory X Days in the perioD
Costs of goods sold
Average collection period ratio (average days receivable)
Average collection period ratio, also known as average days receivable, looks at the average number of days customers take to pay for your products or services.
The quicker you collect your accounts receivable, the lower your average days receivable, and the sooner you have access to this cash to use in your business. Most companies want to keep the average days receivable between 30 and 45 days, but the standards for this KPI depend on the industry in which you operate.
To improve payment collection, you may want to establish clearer credit policies and set out collection procedures. For example, to encourage your clients to pay on time, you can offer incentives or discounts. You should also compare your policies to those in your industry, to ensure you remain competitive.
Average collection period ratio formula
1. Calculate average accounts receivable
Starting accounts receivable value + Ending accounts receivable value
2
2. Calculate average days receivable
Average accounts receivable X Days in the period
Revenue
Average days payable ratio
The average days payable ratio measures the average number of days it takes for a company to pay its suppliers.
Your average days payable should not be too high or too low:
- A high ratio indicates that your business is paying suppliers beyond the accepted collection periods, meaning that you are paying interest on your purchases, which in turn could affect your business’s credit rating. An increasing ratio can indicate that a company is having difficulty paying its bills.
- A low ratio indicates that your business is not taking advantage of your suppliers’ payment terms and that you are unable to take full advantage of their purchase credit.
Average days payable ratio formula
1. Calculate average accounts payable
Starting accounts payable value + Ending accounts payable value
2
2. Calculate average days payable
Average accounts payable x Days in the period
Costs of goods sold
Cash conversion cycle
The cash conversion cycle measures how fast your company can convert its cash on hand into inventory, and then convert inventory back into cash.
Figuring out how long this cycle takes allows you to understand how many days your company’s cash will be tied up.
A positive cash conversion cycle means that your daily operations are tying up cash. You may need extra financing to support the business and pay your suppliers on time.
A negative cash conversion cycle means your day-to-day operations are moving cash quickly through the business and you will not have any problem paying supplier invoices.
Cash conversion cycle formula
Average days inventory + Average days receivable - Average days payable
Inventory turnover ratio
The inventory turnover ratio tells you how fast your goods are selling. It allows you to see how long it takes for inventory to be sold and replaced during the year. 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 costly it becomes.
Assessing your inventory turnover is important because gross profit is earned each time such turnover occurs. Inventory turnover ratio will help you identify areas for improving your buying practices and inventory management. For example, you could analyze your purchasing patterns 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.
Inventory turnover formula
Inventory turnover ratio is calculated by dividing total purchases by average inventory in a given period.
Cost of goods sold
Average inventory
Profitability ratios
Profitability ratios are used to evaluate how much money your business is making or losing.
These are the ratos to use when you want to know how much profit you're earning.
Examples of profitability ratios
Gross profit margin
Gross profit margin is the amount of money a company has left after paying all the direct costs of producing or purchasing the goods or services it sells.
The higher the gross profit margin, the more money the company can afford for its indirect costs and other expenses like interest.
The gross profit margin is expressed in dollars while the gross profit margin ratio is shown as a percentage of revenue. Both are often referred to as gross margin.
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 number of years. Business owners and finance professionals use them as a measure of a company’s operational performance over time and to compare and rank groups of companies based on their performance.
Gross profit margin formula
The gross profit margin is calculated by subtracting direct expenses or cost of goods sold (COGS) from net revenue (gross revenues minus returns, allowances and discounts). That number is divided by net revenues, then multiplied by 100% to calculate the gross profit margin ratio.
(net revenue - direct expenses)
Net revenue
X 100%
Net profit margin
Net profit margin reveals the amount of profit you’re taking in. It measures how much a company earns (usually after taxes) relative to its sales. A company with a higher net profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities.
The standards for this KPI depend on the industry in which your company operates.
Net profit margin formula
net income
Revenue
X 100%
Return on assets ratio
Return on total assets ratio calculates how well the company’s various resources (assets) are being used. The results of this ratio are often used to compare a business to its competitors.
It should also be noted that average ratios 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 few hard assets to operate.
Return on assets formula
Earnings after tax
Total assets
X 100%
Return on equity
Return on equity (ROE) measures how well the business is doing in relation to the investments made.
Like the return on total assets ratio, it is often used by business owners to compare how much the company is earning for each dollar invested in the company. It can also be useful for a business to examine the development of its own return on equity ratio over time.
Return on equity formula
Return on equity is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity and then multiplying the result by 100%.
Earnings after tax
ShareholdeRs' equity
X 100%
Cross-sectional analysis
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 three 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
Leverage ratios measure the overall debt level of a business, as well as a business’s ability to repay new and existing loans.
These are ratios to use when you want to know how extensively you’re using debt to support your business.
Examples of leverage ratios
Debt-to-equity ratio
The debt-to-equity ratio measures how much you are using debt to finance your business relative to equity.
High ratios indicate the company relies heavily on debt. While lower ratios point to a healthier reliance on debt, although it can sometimes point to an overly prudent approach to investing.
Debt-to-equity ratio is 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.
Debt-to-equity ratio formula
Total liabilities
Shareholders' equity
Debt-to-asset ratio
Debt-to-asset ratio is similar to debt-to-equity ratio. It determines a company’s level of indebtedness, in other words, the proportion of its assets that is owned by its creditors.
This ratio shows that most of the assets are financed by debt when the ratio is greater than 1.0.
Debt-to-asset ratio formula
Total liabilities
Assets
Debt service coverage ratio
The debt service coverage ratio (also known as the debt servicing ratio) measures how much EBITDA (earnings before interest, taxes, depreciation and amortization) a company generates for every dollar of interest and principal paid.
Higher ratios are preferable because they indicate your company can easily service its debt.
The debt service coverage ratio is widely used by bankers and investors to understand the level of indebtedness of a company and its prospects moving forward.
Debt service coverage ratio formula
Ebitda
(Interest+Principal)
Accessing and calculating ratios
To determine your ratios, you can use a variety of online tools such as BDC’s financial tools or ask your financial advisor, accountant or banker for the most currently used ratios.
How are financial ratios used in decision making?
Lenders looking at your balance sheet will use financial ratios to determine the stability and health of your business.
They may also make financial ratios a part of your business loan agreement. For instance, they may require that you keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities. This type of request is called a covenant.
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 the fluctuations every company experiences.
Which ratios are relevant to your business?
Every ratio gives you a different insight into your business; how you use them depends on your particular goals.
If you’re looking to grow and need to raise capital, for example, your net profit margin will be key. “The more profit you can show, the better your chances are of raising the cash you need,” says Bourret.
On the other hand, if you’ve launched a new product, you’ll want to track your inventory turnover to make sure you’re aligned with demand. “You want to see that the inventory you keep isn’t old news, that people want to buy the product.”
You always want to be adapting and innovating, and ratios can help you do that.
Some ratios are important to specific industries:
- Occupancy ratio in the hotel sector
- Capital adequacy ratio in banking
- Sales per square foot in retail
- Customer lifetime value to customer acquisition cost ratio in the tech sector
Know which ratios give the information most relevant to your sector.
How to use financial ratios
Once you’ve determined which ratios to use, compare the results over time to pick out trends or changes in your business performance.
For example, if your net profit margin climbed regularly for three years and then took a dip, what changed?
- Were your revenues down in one particular quarter?
- Have your costs gone up?
- Do you need to take any actions?
Use ratios to drive strategy
The insights that come from the ratios you use should shape the direction of your business plan. “Status quo can kill the potential of a business,” says Bourret. “You always want to be adapting and innovating, and ratios can help you do that.”
For example, if you’re not turning over your receivables fast enough, you may have a cash flow problem. You can address that by changing your procedures or company culture to collect payments more proactively. Or if you see your inventory is turning over too slowly, maybe you need to look at your product mix and either add something new or get rid of something old.
Bourret says ratios are a major part of your profit-making arsenal. “Use them right and you end up with more money in your pocket.” If you’re not sure which ones are right for your business, or how to use them, get advice from your accountant or a BDC business advisor. An expert can help you zero in on where you need to focus your efforts.
Where can I find industry financial ratios?
Ratios also help you see how your business compares to others in your industry.
While every industry is different, knowing the industry average gives you a general sense of where you want to be. Average ratios are also available for complete sectors and companies of comparable size.
Industry-standard data is available for a fee from a variety of sources. Industry Canada’s Financial Performance Data, offers basic financial ratios by industry, all based on Statistics Canada data.
Next step
Discover how to use financial ratios to track and analyze your company’s development by downloading the free BDC guide, Monitoring Your Business Performance.
