How to use Financial Ratios

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 as to 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:

Leverage Ratios

These ratios indicate the 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.

Liquidity Ratios

These ratios measure the businesses 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.

Efficiency Ratios

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.

Profitability Ratios

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 on 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.

 

Resources

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

http://www.rmahq.org/annual-statement-studies/

  • Almanac of Business and Financial Ratios ($)

https://www.amazon.com/Almanac-Business-Industrial-Financial-Ratios

  • Financial Studies of Small Business ($ or library)

http://www.worldcat.org/title/financial-studies-of-the-small-business/oclc/45625113

  • Bank Rate Small Business Ratio Calculators

http://www.bankrate.com/nsccan/news/biz/bizcalcs/ratiocalcs.asp

 

Reference

Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.

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David Harkins is a business strategist, speaker, and teacher.

He is the founder and executive consultant at David Harkins Company. In his spare time, he writes hikes, explores, and creates art. Although, not necessarily in that order.

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Calculating Profitability Ratios

Profitability Ratios evaluate the financial viability of a business and provide a measure of comparison and performance to the industry in which the business falls.

These ratios include:

NET MARGIN RATIO

The Net Margin Ratio measures how much a company earns after taxes relative to its sales. The formula is as follows:

Net Profit Margin = Net Profit/Revenue

A higher net profit margin tells the investor the business is more efficient and flexible and capable of taking on new opportunities.

 

OPERATING PROFIT MARGIN RATIO

The Operating Profit Margin Ratio measures earnings before interest and taxes (EBIT). The formula is as follows:

Operating Profit Margin = Operating Income/Net Sales

This gives the investor an idea of whether they want to invest in a company and bankers an idea of whether they should consider providing additional debt financing.

 

RETURN ON ASSETS RATIO

The Return on Assets Ratio measures how well management is using the company's resources. The formula is as follows:

Return on Assets = Net Income/Total Assets

This will vary widely by industry but it gives investors an idea of how well the company is leveraging its assets to benefit the investment return.

 

RETURN ON EQUITY RATIO

The Return on Equity Ratio measures how well the business as an investment is doing relative to the investment by its shareholders. The formula is as follows:

Return on Equity = Net Income/Shareholder's Equity

This helps investors understand how much money the company is earning for each invested dollar and may be a good predictor of return for their investment.

While these formulas are straightforward, I have created a spreadsheet calculator for readers to use an explore. If you're interested, you can download the Efficiency Ratio Calculator using the button below. If you would like to learn more about Financial Ratios and how they may be used, read the post, Financial Ratio Analysis and the Entrepreneur.

 

 

 

A few notes on this calculator:

  • This calculator is an example and is for use as is. It is not supported in any way. It is not intended to be a tool to use without customization based on the specifics of an entrepreneurial venture and its unique financial statements.
  • This calculator is only an example to give the reader an idea of how such a tool can be developed. The numbers within are not based on a real business. I compiled this as an offshoot of work in a graduate class, but I have created developed similar models for entrepreneurial ventures. Each business venture is different, and so is the ratios used and considered for that enterprise.
  • Financial Ratio calculations are done annually using actual numbers. This model can be used in that way. It can also be used to calculate and review ratios monthly. Monthly numbers would allow the reader to track improvements over time.
  • All of the “Bold Blue” text areas can be changed to demonstrate how the interactivity might work. No other data can be changed.
  • Formulas can be seen in each of the cells (mouse over it), but only the values in the “Bold Blue” text area can be changed.
  • By downloading you acknowledge this is for personal use only. It is not to be sold or distributed in any way.

 

Reference

Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.

David Harkins is a business strategist, speaker, and teacher.

He is the founder and executive consultant at David Harkins Company. In his spare time, he writes hikes, explores, and creates art. Although, not necessarily in that order.

Connect with him on social media below:

Calculating Efficiency Ratios

Efficiency Ratios provide additional insights into business operations. These are useful in helping an investor or lender spot key problem areas related to inventory management, cash flow, and collections.

These ratios include:

INVENTORY TURN-OVER RATIO 

The Inventory Turn-Over Ratio measures how long it takes for inventory to be sold and replaced during a period (typically a year.) The formula is as follows:

Inventory Turnover = Cost of Goods Sold/Average Inventory*

The longer inventory sits on the shelf, the more it costs the company because gross profit is not realized from the sale. Sales and inventory management are key measures for investors.

*Average Inventory = (Beginning Inventory+Ending Inventory)/2

 

AVERAGE COLLECTION PERIOD RATIO

The Average Collection Period Ratio measures the average number of days customers take to pay for products or services. The formula is as follows:

Average Collection = Account Balances for the Year/Net Sales for the Year

A short average collection period compared to industry standards is preferred by investors.

While these formulas are straightforward, I have created a spreadsheet calculator for readers to use an explore. If you're interested, you can download the Efficiency Ratio Calculator using the button below. If you would like to learn more about Financial Ratios and how they may be used, read the post, Financial Ratio Analysis and the Entrepreneur.

 

 

 

A few notes on this calculator:

  • This calculator is an example and is for use as is. It is not supported in any way. It is not intended to be a tool to use without customization based on the specifics of an entrepreneurial venture and its unique financial statements.
  • This calculator is only an example to give the reader an idea of how such a tool can be developed. The numbers within are not based on a real business. I compiled this as an offshoot of work in a graduate class, but I have created developed similar models for entrepreneurial ventures. Each business venture is different, and so is the ratios used and considered for that enterprise.
  • Financial Ratio calculations are done annually using actual numbers. This model can be used in that way. It can also be used to calculate and review ratios monthly. Monthly numbers would allow the reader to track improvements over time.
  • All of the “Bold Blue” text areas can be changed to demonstrate how the interactivity might work. No other data can be changed.
  • Formulas can be seen in each of the cells (mouse over it), but only the values in the “Bold Blue” text area can be changed.
  • By downloading you acknowledge this is for personal use only. It is not to be sold or distributed in any way.

 

Reference

Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.

David Harkins is a business strategist, speaker, and teacher.

He is the founder and executive consultant at David Harkins Company. In his spare time, he writes hikes, explores, and creates art. Although, not necessarily in that order.

Connect with him on social media below: