Calculating Financial Ratios in Your Financial Statements

Calculating Financial Ratios in Your Financial Statements

By Fahad Suleman, CPA

September 14, 2020

Financial ratios are used to make comparisons between different financial aspects of a business’s performance. These ratios can be compared with the industry standard to seek areas of strength of a business and areas where there is room for improvement in comparison to its individual industry. There are various financial ratios that can be utilized to analyze a business’s performance. These ratios are broken down into the following categories:

1. Liquidity ratios: These ratios provide measure a business’s ability to pay its debts and other liabilities. Some examples of liquidity ratios include:
   1. Current ratio – This ratio indicates a business’s ability to meet its short-term debt obligations with its current assets meaning if the business has sufficient amount of almost liquid resources to pay its debts over the next 12 months. This ratio can be calculated as follows:

Current ratio = Current Assets/ Current Liabilities

A current ratio above 1 means that a business has sufficient current assets to cover its current liabilities for the period, any amount above 1 shows better financial health of the business.

1. Quick ratio – This ratio indicates a business’s ability to meet its short-term debt obligations using only its most liquid assets. Quick ratio only includes assets that presumably can be quickly converted to cash. This ratio can be calculated as follows:

Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable)/ Current liabilities

This ratio provides an indication of business’s strength or weakness where it’s current debt obligations can be met by its most liquid assets. Just like the current ratio, a quick ratio above 1 means that a business has sufficient liquid assets to cover its current liabilities for the period, any amount above 1 shows better financial health of the business.

1. Net working Capital – This amount provides the difference between the current assets and current liabilities of a business. Net working capital can be calculated as follows:

Net Working Capital = Current assets – Current liabilities

High net working capital amount portrays financial strength of a business as it has the ability to deploy this amount towards growth of the business after covering its current liabilities.

2. Activity Ratios: These ratios provide a business’s efficiency in operations. Usually these ratios include turnover ratios which indicate how efficient the business is in converting its current accounts receivables in to cash, inventory into sales etc. Some of the main examples of the activity ratios are:
   1. Accounts Receivables Turnover – Accounts receivable turnover is the number of times per period that a business collects its average accounts receivables. This ratio can be calculated as follows:

      Accounts receivable Turnover = Net Credit Sales/Average accounts receivable

      This ratio provides an evaluation of business’s ability to collect receivables from its clients in a timely fashion. A high receivables turnover in comparison to the industry shows the financial strength of a corporation to collect the accounts receivable in a timely fashion and using that cash towards operations of the business.

   2. Days sales in Receivables – This ratio provides the number of days it takes a business to collect cash on its credit sales. This ratio in number of days can be calculated as follows:

Days sales in receivable = 365 days / (Net credit sales/ Average accounts receivable)

As cash is crucial to any business, efficiency on collection of cash provides a business with the liquidity required to meet its obligations. The lower the number of days’ credit sales are in receivable for a corporation shows a business’s efficiency in collection of the account receivables on credit sales.

1. Inventory Turnover – This ratio can be used to measure the overall efficiency of a product business. This ratio shows the amount of times average inventory has been sold and replaced during a period. This ratio can be calculated as follows:

   Inventory turnover = Cost of goods sold/average inventory during the same period

   Higher inventory turnover ratios indicates that the business is able to sell its inventory in short periods of time during the year which paint a picture of a financially strong business.

3. Leverage ratios: These ratios provide an indication on business’s ability to cater its long-term debt. Leverage ratios portray how a business’s assets and operations are financed (either through debt or equity). Some of the main example of leverage ratios are:
   1. Debt to Equity ratio – This ratio provides a guidance regarding how much of the business is financed through debt or equity. This ratio provides indication on dependence of a business on debt to continue its operations. This ratio can be calculated as follows:

      Debt to equity ratio = Total debt/Total Equity
      A debt to equity ratio varies between different industries but a lower ratio would indicate a healthier business which is not too reliant on debt to finance its activities.

   2. Debt to Assets ratio – This ratio provides guidance regarding how much of the business’s assets are financed by debt. This ratio can be calculated as follows:

      Debt to equity ratio = Total debt/ Total assets

      A lower debt to asset ratio will indicate that the business is healthy and only a small portion of the assets are being financed through debt.

   3. Interest coverage ratio – This ratio measures how many times a business can cover its current interest obligations with its available earnings. This ratio can be calculated as follows:

      Interest coverage ratio = Net income before interest and income tax /Interest expense

      A higher interest coverage ratio indicates a better financial position for the business as it has sufficient operating earnings to cover its interest obligations.

4. Profitability ratios: Profitability ratios help measure how efficiently a company is using its resources to generate revenue and profits. Performance ratios provide a snapshot of business’s profitability at various stages of operations. Some of the main example of performance ratios are:
   1. Gross Profit Margin – This ratio portrays the gross profitability of the product or services being sold by the business. This ratio can be calculated as follows:

      Gross profit margin = Gross profit/Revenue

      The Higher amount of gross profit margin indicate that the business is able to sell its product or services for a good price in comparison to its cost of goods sold.

   2. Net Profit Margin – This ratio provides the net profitability of a business in comparison to its revenues. This ratio provides the percentage of each dollar collected in revenue which converts into net profit for a business. This ratio can be calculated as follows:

      Net profit margin = Net income/Revenue

      Just like the gross profit margin, higher the amount of net profit margin shows a healthier financial position of the business as it is effective in controlling the amount of its operating expenses.

   3. Return on Assets – This ratio provides an indicator of how profitable the business is in comparison to its assets. This ratio can be calculated as follows:

      Return on assets = Net income/Average total assets

      This ratio portrays the efficiency of the business to utilize its assets to generate income. Just like other profitability ratios, a higher figure for this ratio indicates efficient use of business’s assets.

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