Financial ratios are calculated using a business’s financial information and then using that information for comparative purposes. For example, return on investment (ROI) is the most popular form of a financial ratio.
Ratios like this take one piece of financial measurement and then divide it against another. So how are these ratios applied to financial analysis?
Almost any type of financial statistic can be measured in this way. When analyzing a small business, you will use smaller sets of ratios that identify areas where you need to make improvements.
During a business analysis, financial ratios take center stage in the final report. It always comes back to the bottom line. Areas that need improvement will be leaking money, but sometimes those leaks are very difficult to spot. A business analysis will use financial ratios to show exactly where these leaks are so that management can patch them.
Financial ratios are going to be time-sensitive, though, since a business’s financial scenario changes. They will only show the business at the exact time the figures were taken from the books. So, a retailer looking to improve its spring business would not benefit from an analysis that was taken during the Christmas season. In short, the time that these figures are taken is essential to providing the right information.
Different Types of Financial Ratios and Their Significance
Financial analysis and ratios go hand-in-hand. Think of it as a health check-up for a business. Just like with physical health, a business needs to have its health analyzed regularly. By understanding these ratios, CEOs can start making important business decisions.
A financial analysis of solvency shows whether a business is capable of remaining solvent. It is a measurement of a business’s cash flow as opposed to its net income. In short, it is used to determine the capability of a company to generate cash flow for all liabilities. Other forms only show this comparison in regard to short-term debt. This allows businesses to evaluate their ability to repay long-term debts. Businesses want a solvency ratio of more than 20% to be considered financially sound.
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This ratio is usually compared to that of a relative competitor. The goal here is for your business to have a higher value than that of a competitor or at the very least, a profitability ratio that is on par with the industry average. The most well-known type of profitability ratio is gross profit margin. Businesses use this form of financial analysis to provide insight into margins and returns. It details a company’s ability to transform sales into profits.
Examples of Profitability Ratios
- Gross Profit Margin
- Return on Assets
- Return on Equity
A financial analysis will show a business’s capability to pay its debts through liquidity ratios. It relates to the availability of cash and compares it to current liabilities. Companies must have a certain level of liquidity to pay its bills on time. As the business grows, it will become more liquid. This is extremely important because it shows owners their borrowing limits.
Examples of Liquidity Ratios
- Current Assets/Liabilities
- Quick Ratio
- Cash to Total Assets
- Turnover Ratio
- Cost of Sales/Trade Payables
- Cash Turnover
Leverage ratios are used to determine how dependent a business is on its loans. This ratio is looked at closely by investors and borrowers, so it’s important that companies keep a close eye on it. In most cases, a financial analysis will compare net worth with a company’s liabilities to determine its leverage. The higher the leverage ratio, the more risk to a business. However, there is also the potential for higher returns. Leveraging must be used carefully.
Examples of Leverage Ratios
- Debt to Equity Ratio
- Debt Ratio
- Fixed to Worth Ratio
- Interest Coverage
Market Prospect Ratio
Market prospect ratios are used to compare a business’s financials with the current stock prices of comparable companies. This is valuable for a business that is looking to expand. Investors will analyze this number closer to help them make decisions on whether to invest in a company. It will show them what they should expect to see as a return on their investment.
Examples of Market Prospect Ratios
- Dividend Yield Ratio
- Price/Earnings Ratio
- Dividend Payout Ratio
- Dividend Yield Ratio
The coverage ratio is used in financial analysis to measure a company’s ability to pay its debts. The higher this ratio, the easier it is to meet these obligations. This is another number that gets a lot of attention from analysts because it provides a glimpse into the company’s financial situation. For instance, Research Optimus professionals or other analysts will compile a list of income, expenses, and debts that are then used to come up with an accurate coverage ratio.
Examples of Coverage Ratios
- Interest Coverage Ratio
- Debt Service Coverage Ratio
- Asset Coverage Ratio
- Loan Life Coverage Ratio
Efficiency is used to assess a business’s use of inventory, assets, and credit. It will show how efficiently they are able to collect money for its credit sales or its use of inventory. This information is most valuable for internal use because it shows areas where the business can improve its inventory management, purchasing efforts, and credit terms. This is how management will determine if changes are needed and the nature of those changes.
Examples of Efficiency Ratios
- Annual Inventory Turnover Ratio
- Inventory Holding Period Ratio
- Accounts Receivable Turnover Ratio
Key Benefits of Analyzing by Leveraging Financial Ratios
Financial analysis is a powerful tool that helps businesses to express their financial data both internally and externally. Research Optimus professionals compile data from a company’s competition and analyze the overall market, comparing it to that of the business. There are several benefits to leveraging this information.
- Better Analysis of Financial Statements
- Analyses of Current Market Trends
- Provides Context for Absolute Figures
- Shows you How Well a Business Stands up Against its Competition
- Helps Judge the Efficiency of a Business
- Finds Weaknesses in Business Finances
- Projects Cash Flow and Future Earnings
- Shows a Business’s Short-Term Liquidity
- Provides Insight into Past Results
- Improves the Credit Rating of a Business
Financial Ratio Analysis to Evaluate Businesses and Contribute to Their Growth
Most financial experts will use a process known as trend analysis to collect information. It’s then easy to spot certain patterns within those metrics by using either charts or tables. Trend analysis will help predict events that will come up in the future, allowing CEOs to make better decisions.
There is a downside though. Complications can occur when a business undergoes small changes. These changes usually occur over time, like slowly shifting to a different business model or opening its doors to a new market. Financial analysis is a fundamental part of growing a business. It’s essential to get the most from financial statements.
Accuracy is paramount, a fact that all of our Research Optimus professionals understand too well. Financial ratios are how businesses become more attractive to both lenders and investors. They also provide insight into the position, strength, and profitability of a business.