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Financial ratios are tools used to compare figures in the financial statements of your business. They provide an objective measure on the performance of your business in the past, present, and future to help you determine growth, pay yourself & your employees, and still make a profit.
They are like the gauges on a car’s dashboard telling you what’s happening, such as when gas or battery is too low or when the temperature or oil pressure is too high. Similarly, financial ratios indicate what’s happening in your business that requires your attention.
It’s important to compare financial ratios to previous months, quarters and, most importantly, same periods of prior years. Each ratio gives different insights into the business, showing both improvements and areas of potential concern. Financial ratios are most effective within four areas of business including: Profitability, short-term bill paying ability, borrowing capacity, and growth rates & related trend analysis.
- Understanding profitability
The first set of ratios relates to measuring both profitability and returns on investment.
- Gross margin measures gross profit as a percentage of net sales and indicates how much gross profit is earned on each dollar of net sales. It’s critical to have a sufficient gross margin to cover all selling and general & administrative expenses, one-off non-trading Items, interest on borrowings, and income taxes. For example, in 2020, the average gross margin for a group of Manufacturers and Distributors (“M&D”) in Canada was 30.4% and 22.4% respectively. Each industry has different margins, so you should primarily compare to your industry average.
- Operating margin measures operating profit as a percentage of net sales and indicates how much operating profit is earned on each dollar of net sales. It’s critical to have a sufficient operating margin to cover any one-off non-trading items, interest on borrowings, and income taxes. The average operating margin in 2020 for the same group of M&D was 16.3% and 6.8% respectively.
- Net margin measures overall bottom-line net profit as a percentage of net sales and indicates how much net profit is earned on each dollar of net sales. The average net margin in 2020 for the same group of M&D was 7.2% and 4.2% respectively.
- Return on assets (“ROA”) measures net profit as a percentage of total assets and indicates how efficiently your assets are being used to generate profit in the business, or how much net Profit is earned on each dollar of total assets invested. The average ROA in 2020 for the same group of M&D was 2.5% and 5.0% respectively. Since manufacturers must invest more heavily into plant and equipment, their ROA is generally much lower than distributors.
- Return on owners’ equity (“ROE”) measures net profit as a percentage of total owners’ equity and indicates how much net profit is earned on each dollar of owners’ equity invested in the business. The average ROE in 2020 for the same group of M&D was 11.0% and 4.6% respectively. This implies that Manufacturers generally use more leverage (per item 3. below) in their business than Distributors.
- Understanding short-term bill paying ability or your business’s liquidity
Current and quick ratios are the two liquidity calculations that bankers and suppliers use to evaluate the credit-worthiness of a business before lending funds or shipping goods respectively. These ratios are critical to ongoing operations since businesses can fail if short-term obligations are not met.
- Current ratio measures whether there’s sufficient current assets to pay all current liabilities when due. Typically, a 2:1 ratio is a good current ratio for most businesses, as it indicates there’s $2 of current assets for each dollar of current liabilities. A higher ratio is not necessarily better.
- Quick or acid-test ratio measures the immediate short-term liquidity based on whether there’s sufficient liquid current assets to pay all current liabilities when due. Typically, a 1:1 ratio is a good quick ratio for most businesses, as it indicates indicating there’s $1 of liquid current assets to pay each dollar of current liabilities. A lower ratio suggests solvency issues and related inability to pay current liabilities when due.
- Understanding borrowing capacity or your leverage
The third set of financial ratios relates to measuring the balance between debt and equity. Borrowing for investment purposes is normally done when profits are expected to be much greater than interest on debt. This is called leverage.
There are three leverage calculations that bankers use to measure current and anticipated debt levels against the ability to repay the loan(s) on schedule: Debt-to-equity, interest coverage and fixed payment coverage ratios.
- Debt-to-equity ratio measures total debt outstanding, both current and long-term, compared to total owners’ equity in the business. It indicates how much debt there is compared to each dollar of total owners’ equity. Bankers generally look for low debt-to-equity ratios depending on the nature of the business. Generally, a 2:1 ratio is fine in good economic times; but a lower ratio is advisable in more challenging economic times.
- Interest coverage ratio measures the ability to make interest payments by determining how many times operating profit covers the interest payments on both existing and projected new loans. Bankers typically want the interest coverage ratio to be three times or higher.
- Fixed payment coverage ratio measures the ability to make payments on both loans and leased assets. Bankers typically want fixed payment coverage ratio to be similar to the interest coverage ratio before extending additional financing.
- Understanding growth rates & related trend analysis
When you compare figures on your financial statement between periods, it’s often difficult to know how much a specific figure has changed from the previous period. Using growth rate calculations to measure the percentage change between periods can help you understand how the business is doing based on what’s increasing, decreasing, or staying the same, line-by-line on your income statement.
Growth rates can help you analyze your business trends over time, including the impact of new products and strategy changes. They are particularly useful in comparing prior period net sales and costs/expenses with current period and next year’s budget to help you identify specific favorable or unfavorable trends.
Ron McGregor, CPA, CA, is currently a Part Time Studies Intermediate Accounting Instructor at BCIT trying to motivate students-in-accounts to complete their CPA PREP Program; and is a volunteer with CPABC’s Financial Literacy Program. His professional experience after leaving public practice as an Audit Manager has been primarily in the Senior Financial Management of public companies over many years. For more information, visit CPABC's FinLit site.