Financial Ratios: Power In Numbers
Using data from the balance sheet and income statement, various ratios can be calculated, which can then be compared directly to those of competing companies of varying sizes. Industry trade associations also have industry standards available for comparison. In addition, comparing changes in a company’s ratios over a few years’ time can highlight improvements in performance or a problem needing attention.
Ratios are very simple to calculate — sometimes they are simply expressed in the format “x:y” and other times they are one number divided by another with the answer expressed as a percentage. The following ratio types explain how each of the financial ratios is calculated and what it tells you about your business’s financial health. They can help provide a clear picture of your business’s ability to generate profit, pay its bills on a timely basis and utilize its assets efficiently. For ratios, having a higher value relative to a competitor’s ratio or the same ratio from a previous period is indicative that the company is doing well.
• Profitability ratios assess a business’s ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. Net profit margin, return on assets, and return on equity are the most widely used profitability ratios.
• Operational Efficiency/Employee Productivity ratios measure the efficiency of employees and corporate resources in earning a profit. Three commonly used ratios are revenue, gross profit per full-time employee and asset turnover.
• Liquidity ratios measure a company’s ability to pay off short-term debt. They reflect your company’s ability to cover its expenses. The current ratio and the quick ratio are two ratios that provide an indication of the company’s liquidity.
• Leverage (capital-structure) ratios reflect the extent to which the company uses debt to finance its operations. The debt ratio and the debt-equity ratio are used for this purpose.
Calculating financial ratios is important, but the real value in these numbers comes when they are fully understood. Knowing what it means when your company’s numbers are lower or higher than others is essential. That’s when you can stop looking back on the past and start looking forward to a strong financial future.
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