Financial Ratios - What Are They? What Do They Mean?

By Sarah Hall

Current ratio, quick ratio, and debt-to-equity ratio, these are all a few examples of financial ratios that could give you a quick answer to your business' financial status. Each financial ratio gives you specific information by using numbers from your financial statements. They are easy to use and can become a regular part of your monthly accounting.

 

For example, gross profit margin is a financial ratio. It measures the cost of sales. This ratio is calculated by dividing gross profit by sales. Two simple numbers give you a percentage that can greatly help you analyze your profitability. There are many ratios that give you just as valuable insight as the gross profit margin ration, and Cybertary has conveniently listed and explained them for your use.

FINANCIAL RATIOS

Financial Indicator   Industry Range  

Current Ratio   1.40 to 2.00  

= Total Current Assets / Total Current Liabilities

Explanation: Generally, this metric measures the overall liquidity position of a company. It is certainly not a perfect barometer, but it is a good one. Watch for big decreases in this number over time. Make sure the accounts listed in "current assets" are collectible.


Quick Ratio   0.90 to 2.00  

= (Cash + Accounts Receivable) / Total Current Liabilities

Explanation: This is another good indicator of liquidity, although by itself, it is not a perfect one. If there are receivable accounts included in the numerator, they should be collectible. Look at the length of time the company has to pay the amount listed in the denominator (current liabilities).


Accounts Receivable Days*   10.00 to 40.00 Days  

= (Accounts Receivable / Sales) * 365

Explanation: This number reflects the average length of time between credit sales and payment receipts. It is crucial to maintaining positive liquidity.


Accounts Payable Days*   10.00 to 40.00 Days  

= (Accounts Payable / COGS) * 365

Explanation: This ratio shows the average number of days that lapse between the purchase of material and labor, and payment for them. It is a rough measure of how timely a company is in meeting payment obligations.


Gross Profit Margin   65.00% to 77.00%  

= Gross Profit / Sales

Explanation: This number indicates the percentage of sales revenue that is paid out in direct costs (costs of sales). It is an important statistic that can be used in business planning because it indicates how many cents of gross profit can be generated by future sales.


Net Profit Margin   1.50% to 5.00%  

= Adjusted Net Profit before Taxes / Sales

Explanation: This is an important metric. In fact, over time, it is one of the more important barometers that we look at. It measures how many cents of profit the company is generating for every dollar it sells. Track it carefully against industry competitors. This is a very important number in preparing forecasts.


Payroll to Sales   N/A  

= Payroll Expense / Sales

Explanation: This metric shows payroll expense for the company as a percentage of sales.


Interest Coverage Ratio   3.00 to 14.00  

= EBITDA / Interest Expense

Explanation: This ratio measures a company's ability to service debt payments from operating cash flow (EBITDA). An increasing ratio is a good indicator of improving credit quality.


Debt-to-Equity Ratio   0.90 to 3.00  

= Total Liabilities / Total Equity

Explanation: This Balance Sheet leverage ratio indicates the composition of a company's total capitalization -- the balance between money or assets owed versus the money or assets owned. Generally, creditors prefer a lower ratio to decrease financial risk while investors prefer a higher ratio to realize the return benefits of financial leverage.


Debt Leverage Ratio*   N/A  

= Total Liabilities / EBITDA

Explanation: This ratio measures a company's ability to repay debt obligations from annualized operating cash flow (EBITDA).


Return on Equity*   8.00% to 20.00%  

= Net Income / Total Equity

Explanation: This measure shows how much profit is being returned on the shareholders' equity each year. It is a vital statistic from the perspective of equity holders in a company.


Return on Assets*   6.00% to 10.00%  

= Net Income / Total Assets

Explanation: This calculation measures the company's ability to use its assets to create profits. Basically, ROA indicates how many cents of profit each dollar of asset is producing per year. It is quite important since managers can only be evaluated by looking at how they use the assets available to them.


Fixed Asset Turnover*   2.00 to 7.00  

= Sales / Gross Fixed Assets

Explanation: This asset management ratio shows the multiple of annualized sales that each dollar of gross fixed assets is producing. This indicator measures how well fixed assets are "throwing off" sales and is very important to businesses that require significant investments in such assets. Readers should not emphasize this metric when looking at companies that do not possess or require significant gross fixed assets.


* These formulas have been scaled to approximate annual statistics.

READER: Financial analysis is not a science; it is about interpretation and evaluation of financial events. Therefore, some judgment will always be part of analyses. Before making any financial decision, always consult an experienced and knowledgeable professional (accountant, banker, financial planner, attorney, etc.)


 

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