Whether you’re new to running a business or a veteran to the game, understanding financial ratios is vital to gaining insight into key company factors such as liquidity and profitability. These insights help you make smart business decisions and ensure long-term growth for your company.
Financial analysis is a major tool in analysing your company’s financial health over time and comparing your business’s performance against your competitors.
This article explores the major types of financial ratios that every business owner should know.
What is Ratio Analysis?
Ratio analysis is a method to assess a company’s financial health using company statements. It analyses the company’s performance in several areas, including liquidity, efficiency, leverage, and profitability.
Ratio analysis includes a number of different financial ratios which are used to predict the financial stability and long-term growth of a business.
Ratio analysis needs to be compared to and used in conjunction with other company data in order to determine the company’s performance and identify areas of improvement.
What Are Financial Ratios?
Financial ratios are basic calculations that use data from a company’s financial statements to provide insights into the company’s performance and financial health.
Financial ratios perform quantitative analysis based on financial data such as the company’s income statement, cash flow statement, and balance sheet. This analysis helps the company assess its financial health in a number of areas, such as liquidity, profitability, growth, valuation, leverage, etc.
Financial ratios can be used by internal shareholders of the company, such as the owners and employees, as well as external shareholders, such as the company’s competitors, regulatory authorities, and financial analysts.
Importance of Financial Ratios For Businesses
Financial ratios are the best indicators of your company’s financial health. They help stakeholders perform competitor analysis, market valuation, and performance management.
One of the biggest benefits of financial ratios is that they can help you measure your company’s ability to settle debts and liabilities in the short- and long-term. They also help manage working capital and short-term funding requirements.
Financial ratios can also help you measure your business’s returns on capital investment and assess how efficient your company’s resource and cost allocation is. They can also help you calculate profit margins and identify profitability trends.
All of these benefits make financial ratios crucial in ensuring the long-term financial success and growth of your business.
Types of Financial Ratios in Business
There are five main categories of financial ratio that are useful for businesses:
1. Liquidity ratios: Your company requires liquidity in order to meet short-term obligations, such as short-term debts. Liquidity ratios measure your company’s ability to pay off such outstanding debts by assessing the quick or current assets of the business.
Some key liquidity ratios are:
1. Quick ratio
2. Current ratio
3. Working capital ratio
2. Leverage ratios: Also known as solvency ratios, leverage ratios measure and indicate your company’s long-term financial state by assessing its ability to pay long-term deficits, such as long-term debts and the associated interest.
Some key leverage ratios are:
1. Interest coverage ratios
2. Debt-assets ratios and
3. Debt-equity ratios
3. Efficiency ratios: You can measure how efficiently your company utilises its resources by using efficiency ratios. Efficiency ratios calculate the relationship between your business’s assets and sales and evaluate how effectively the company maximises profits through its assets and liabilities.
Some key efficiency ratios are:
1. Turnover ratio
2. Inventory turnover
3. Day’s sales in inventory
4. Profitability ratios: Profitability ratios measure how much profit your company generates from its operations. They examine the gains of the company and assess the effectiveness of its financing strategies and choices.
Some key profitability ratios are:
1. Return on assets
2. Return on equity
3. Gross margin ratio
5. Market value ratios: Market value ratios are usually used by external shareholders like market analysts and investors. They are used to measure the value of a company. Shareholders use these ratios to evaluate and compare different public companies, which can help them make investment decisions.
Some key market value ratios are:
1. Price-to-earnings
2. Price-to-sales
3. Enterprise value
Limitations of Financial Ratios
The key limitation to remember when computing financial ratios is that they cannot be used in isolation. Different types of financial ratios should be used in combination with each other to gain a holistic view of the company’s financial performance and where it stands next to its competitors.
Another limitation of financial ratios is that external shareholders, such as investors, can be tricked by companies presenting their stock and company ratios as more attractive than they actually are. Investors should thus familiarise themselves with the variables affecting these ratios, the information they can or cannot communicate, and how these ratios can be manipulated.
How to Make the Most of Financial Ratios
The following tips can help ensure that you get the most out of financial ratios:
1. Use accurate financial numbers when calculating financial ratios.
2. Identify performance trends by comparing financial ratios across periods.
3. Measure company performance by utilising relative competitor and industry benchmarks.
4. Use balance sheet averages to calculate ratios whenever possible.
5. Ensure a holistic view of the company’s performance by using the balance sheet, income statement, and cash flow statement to calculate and analyse financial ratios
6. Ensure correct interpretations of financial ratios when considering them for business decisions
Wrapping Up
Regular and accurate assessment of your company’s performance is key to long-term success. Financial ratios help you gain insight into how your company is performing compared to competitors and your business goals.
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FAQs
The four kinds of financial ratios are liquidity ratios, activity (or efficiency) ratios, profitability ratios, and leverage ratios
Ratio analysis helps a business check its financial health. The seven financial ratio analysis types are liquidity ratios, profitability ratios, efficiency ratios, solvency ratios, quick ratios, coverage ratios, and market ratios.
Liquidity, leverage, efficiency, profitability, and market value are the five major categories of ratios for businesses.
20 February 2025
5 mins read
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