In an earlier post, Financial Ratio Analysis and the Entrepreneur, I shared some insights on Financial Ratio Analysis and how investors and lenders may consider and use financial ratios to determine whether to invest or lend to an entrepreneur. Entrepreneurs should also understand how to use financial ratios in the regular course of business operations. Each financial ratio has a purpose, and when compared to industry benchmarks, a ratio can provide insights into a venture’s performance as well as help set stretch goals for business improvements and growth.
The most common financial ratios used by investors and lenders include:
These ratios indicate long-term solvency and highlight the extent long-term debt is used to support the venture. Leverage Ratios include:
- Debt-to-Equity Ratio which measures how much debt is used to run the business.
- Debt-to-Asset Ratio which measures the percentage of the company’s assets that are financed by creditors.
Learn more about Leverage Ratios and how to calculate them here.
These ratios measure the business’s ability to cover its debt and provide a high-level overview of financial health. Liquidity Ratios include:
- Current Ratio which estimates the company’s ability to generate cash to meet its short-term commitments.
- Quick Ratio which measures the ability to access cash quickly for immediate demands.
Learn more about Liquidity Ratios and how to calculate them here.
These ratios offer insights into operations and help to spot problem areas related to inventory management, cash flow, and collections. Efficiency Ratios include:
- Inventory Turn-over which examines how long it takes inventory to be sold and replaced within a year.
- Average Collection Period which looks at the average number of days it takes customers to pay for goods or services.
Learn more about Efficiency Ratios and how to calculate them here.
These ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry. Profitability Ratios include:
- Net Profit Margin which measures how much a company earns after taxes relative to sales.
- Operating Profit Margin which measures earnings before interest and taxes (EBIT).
- Return on Assets which provides insights into how well management is using the company’s resources.
- Return on Equity which measures how much the company is earning for each invested dollar.
Learn more about Profitability Ratios and how to calculate them here.
As I mentioned in the previous post, these are just a few of the ratios used in determining the health and viability of a given business. Together with other factors such as customer acquisition costs, these ratios provide a great set of tools for managing an entrepreneurial venture. Fully understanding these ratios and the implications on the venture will be beneficial for an entrepreneur before he or she seeks additional investment or debt financing.
Here are a few resources that might be beneficial for identifying industry comparisons for your industry:
- RMA Annual Statement Studies. Data on business for comparisons
- Almanac of Business and Financial Ratios ($)
- Financial Studies of Small Business ($ or library)
- Bank Rate Small Business Ratio Calculators
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
4 thoughts on “How to use Financial Ratios”
Thanks for clarifying the financial ratios for a business owner. I have to share some of these posts with my small business owner friends. These are all important topics to know about.
Wonderful! Share away. One of my primary purposes behind this blog is to teach and explain. I am grateful to you for helping me to do that by sharing.
David, with so many ratios, I feel like I need flash cards. But thank you for breaking it out in categories. Each set is a piece to the puzzle that really tell if a business can afford stay in business
My pleasure, Michelle. If i can provide any assistance with ratios do let me know.