Understanding Financial Ratios Key Metrics for Evaluating Business Performance
Financial ratios use numerical values derived from financial statements (balance sheet, income statement and cash flow statement) to analyze business performance. They are an essential tool for quantifying business performance.
The quick ratio, also known as the acid test ratio, sums a company’s current assets (cash, marketable securities and accounts receivable) and divides it by its current liabilities. Inventory is excluded from the calculation.
Profitability Ratio
Profitability ratios provide insight into a company’s current state and the future potential for growth. They can help entrepreneurs formulate concrete ways to improve profits and attract investors.
For example, net profit margin reveals how much after-tax profit is made for every dollar of assets owned by a business. Companies with higher margins than their competitors are considered more efficient, flexible and able to take advantage of opportunities as they arise.
Ratios can also be used to compare performance over time or against industry benchmarks. It’s important to run them on a regular basis, taking into account seasonality and other temporary fluctuations.
Cash Flow Ratio
A company with enough cash or cash equivalents to cover its short-term debt and liabilities is considered financially strong. It’s a more conservative measure than other liquidity ratios, as it only considers cash and cash-equivalent holdings (excluding accounts receivable).
Lenders often use this ratio as part of their lending criteria and should be evaluated on a monthly basis. It’s also useful to compare the ratio against industry and competitor averages. This is especially helpful for identifying industry seasonality. The cash ratio can be improved by turning over inventory more quickly, reducing working capital and lowering payment terms with customers.
Working Capital Ratio
The working capital ratio illustrates a company’s ability to convert its current assets into cash. A higher ratio indicates more cash-on-hand, but it can also mean that the company is hoarding money rather than reinvesting it in its business. A comparatively low ratio can indicate that the company could have trouble paying its bills or taking advantage of new business opportunities that require quick cash.
To gain perspective on your company’s current liquidity, compare your ratios against those of similar companies in your industry. Use these comparisons to identify trends and improve your business’s efficiency and flexibility.
Days Payables Outstanding
The Days Payable Outstanding metric measures the average time it takes for your business to settle its payables with suppliers. Ideally, your business should be able to use its current assets and cash equivalents to cover all of its short-term debts.
Depending on the nature of your business, you may have different payment terms with your suppliers. For example, a clothing store might need to keep inventory short and have fast turnover, while airplane manufacturers have high-value inventory that requires long periods of time for production.
Using industry benchmarks and calculating your own ratios over time helps you gauge whether your business is on track for success. You can also compare your company to its peers in the same industry and identify areas for improvement.
Accounts Receivables Ratio
The accounts receivable turnover ratio is a measure of how quickly a company turns its invoices into cash. It can be a good indicator of efficient collections practices and quality customers who pay their debts promptly.
This ratio is not without its limitations, however. It’s important to clarify how the ratio is calculated because some companies use total credit sales instead of net credit sales, which inflates results.
Additionally, the turnover ratio can vary greatly throughout the year due to seasonality and other factors. This makes it important to look at the ratio over a long period of time.
Quick Ratio
This financial ratio divides a company’s quick assets — cash and liquid investments such as marketable securities and accounts receivable — by its current liabilities, which are any immediate debts that the business must pay. The calculation excludes prepaid expenses and inventory, which can take a significant amount of time to convert into cash. The quick ratio is used by investors, suppliers and lenders to assess a company’s ability to pay its debts on time.
However, this metric is not without limitations and requires context and qualitative factors when making comparisons between companies in different industries.
Days Working Capital
The Days Working Capital (DWC) ratio is a measure of how long it takes for the company to turn its initial investments in working capital into revenue. It indicates if the company is efficient in managing its inventories, collecting its receivables and paying its payables.
This financial metric differs from the current ratio because it only considers assets that can quickly be converted into cash, including cash and cash equivalents, marketable securities and accounts receivable. The quick ratio excludes inventory and prepaid expenses, which might not be easily converted into cash.