Key performance indicators (KPIs) were top of mind for finance teams surveyed for NetSuite’s Winter Outlook report. Finance teams said they’re focused on using data more effectively, producing better reports on KPIs and finding ways to save money. But executives who didn't work in finance had different priorities. One possible explanation for the rift, according to the report analysts, is that financial data needs context. It needs an accompanying narrative to illustrate the point and show the state of the business' finances. One way to simplify the data and make it more accessible for investors, lenders and internal stakeholders is using financial ratios.
What Is a Financial Ratio?
A financial ratio is a measure of the relationship between two or more components on the company’s financial statements. These ratios give you a quick and straightforward way to track performance, benchmark against those within an industry, spot trouble and proactively put solutions in place.
Why Is Measuring Financial Ratios Important?
Ratios help business leaders compare the company with competitors and more generally with those within their given industry. They enable a business to benchmark its performance and target areas for improvement. They help companies see problematic areas and put measures in place to prevent or ease potential issues. And if the business is seeking outside funding from a bank or an investor, financial ratios provide those stakeholders with the information needed to see if the business will be able to pay the money back and produce a strong return on investment.
18 Key Financial Ratios to Track
Financial ratios measure profitability, liquidity, operational efficiency and solvency.
Ratios that help determine profitability
The data used to calculate these ratios are usually on the income statement.
Gross profit margin:
Higher gross profit margins indicate the company is efficiently converting its product (or service) into profits. The cost of goods sold is the total amount to produce a product, including materials and labor. Net sales is revenue minus returns, discounts and sales allowances.
Gross profit margin = net sales – cost of goods or services sold/net sales X 100
Net profit margin:
Higher net profit margins show that the company is efficiently converting sales into profit. Look at similar companies to benchmark success as net profit margins will vary by industry.
Net profit margin = net profit/sales X 100
Operating profit margin:
Increasing operating margins can indicate better management and cost controls within a company.
Operating profit margin = gross profit – operating expenses/revenue X 100
Gross profit minus operating expenses is also known as earnings before interest and taxes (EBIT ).
Return on equity:
This measures the rate of return shareholders get on their investment after taxes.
Return on equity = net profit/shareholder’s equity
Ratios that measure liquidity
These metrics measure how fast a company can pay back its short-term debts. Use information from the balance sheet and the cash flow statement for these ratios.
Working capital or current ratio:Can the business meet short-term obligations? A working capital ratio of 1 or higher means the business’ assets exceed the value of its liabilities. The working capital ratio is also known as the current ratio.
Working capital ratio = current assets/current liabilities
This measure is similar to the working capital ratio, but only takes cash and cash equivalents into account. This will not include inventory.
Cash ratio = cash and cash equivalents/current liabilities
Similar to the cash ratio, but also takes into account assets that can be converted quickly into cash.
Quick ratio = current assets – inventory – prepaid expenses/current liabilities
Cash flow to debt ratio:
Measures how much of the business' debt could be paid with the operating cash flow. For example, if this ratio is 2, the company earns $2 for every dollar of liabilities that it can cover. Another way of looking at it is that the business can cover its liabilities twice over.
Cash flow to debt ratio = operating cash flow/debt
There are a couple ways to calculate the operating cash flow. One is to subtract operating expenses from total revenue. This is known as the direct method.
Operating cash flow to net sales ratio:
Measures how much cash the business generates relative to sales. Accounting Tools says this number should stay the same as sales increase. If it’s declining, it could be a sign of cash flow problems .
Operating cash flow to net sales ratio = operating cash flow/net sales
Free cash flow to operating cash flow ratio:
Investors usually like to see high free cash flow. And a higher ratio here is a good indicator of financial health.
Free cash flow = cash from operations — capital expenditures
Free cash flow to operating cash flow ratio = free cash flow/operating cash flow
Cash equivalents are investments that mature within 90 days, such as some short-term bonds and treasury bills.
Ratios that measure operational efficiency
These ratios point to the company’s core business activities. They’re calculated using information found on the balance sheet and income statement.
How efficient and productive are employees? This ratio is a good way to see how efficiently a business manages its workforce and should be benchmarked against similar businesses.
Revenue per employee = annual revenue/average number of employees in the same year
Return on total assets:
Looks at the efficiency of assets in generating a profit.
Return on total assets = net income/average total assets
Calculate average total assets by adding up all assets at the end of the year plus all the assets at the end of the prior year and divide that by 2.
Examines how efficiently the company sells inventory. Start with the average inventory by taking the inventory balance from a specific period (a quarter, for example) and add it to the prior quarter inventory balance. Divide that by two for the average inventory.
Inventory turnover = cost of goods sold/average inventory
Accounts receivable turnover:Measures how well a company is managing collections. A higher rate usually means customers are paying quickly. You’ll need to know the average accounts receivable. To calculate that, take the sum of starting and ending receivables over a period and divide by two. This period can be a month, a quarter or a year.
Accounts receivable turnover = net annual credit sales/average accounts receivable.
This is a related measure to give a business the sense of how long it takes for customers to pay their bills. Here’s the formula to calculate the average collection period for a given year.
Average collection = 365 X accounts receivable turnover ratio/net credit sales
To calculate net credit sales, use this formula:
Net credit sales = sales on credit — sales returns — sales allowances
Days payable outstanding (DPO):
The average number of days it takes the company to make payments to creditors and suppliers. This ratio helps the business see how well it's managing cash flow. To calculate DPO, start with the average accounts payable for a given time (could be a month, quarter or year):
Average accounts payable = accounts payable balance at beginning of period — ending accounts payable balance/2
DPO = average accounts payable/cost of goods sold x number of days in the accounting period
The resulting DPO figure is the average number of days it takes for a company to pay its bills.
Days Sales Outstanding:
Shows how long on average it takes for customers to pay a company for goods and services.
Days sales outstanding = accounts receivable for a given period/total credit sales X number of days in the period
Ratios that help determine solvency
These ratios look at a business’ ability to meet long-term liabilities using figures from the balance sheet.
Debt to equity ratio:
An indication of a company’s ability to repay loans.
Debt to equity ratio = total liabilities/shareholder’s equity
Debt to asset ratio:
Gives a sense of how much the company is financing its assets. A high debt to asset ratio could be a sign of financial trouble.
Debt to asset ratio = total liabilities/total assets
How to Use Financial Ratios
These financial ratios provide easy-to-access and insightful information for potential investors and lenders. The ratios are a way for startups to show investors that the business is financially solid. The ratios related to accounts receivable are especially important for small businesses seeking loans. According to peer-to-peer lending marketplace Funding Circle , banks appraise eligible receivables at 70%–80% of their value for asset-backed loans.
Financial ratios are for more than just securing funding. They can be used to provide KPIs and help guide strategic decisions to meet business goals. For example, calculating inventory turnover and comparing it to industry averages helps a company strike a balance between having too much cash tied up in inventory or too little inventory on hand to meet demand.
The Federal Reserve Bank of Chicago found that there is a direct correlation between financial management and financial health of small businesses. And the more often a small business analyzes the numbers from sound financial management practices, the higher its success rate. Those that do it annually, the U.S. Small Business Administration says, have a success rate as low as 25%. Done monthly or weekly, those rates climb to 75–85% and 95% respectively. And these small business financial ratios are a way to see and track insightful information.
All of this information will come from a company’s financial statements. Using technology to automate the accounting process to create the static financial statements saves time and eliminates human error. Using small business accounting software gives you more accurate and complete financial information and makes calculating the financial ratios quicker and simpler. Understanding the context of the ratios is the important first step. But automating the processes behind the ratios gives you a clearer, more accurate and easier-to-understand picture of your company’s finances.