Ask the Expert… What are financial ratios and how can they be used to improve my business?
Financial ratios are evaluation tools that can help you understand your business’s performance and compare it with others in your industry. They measure the relationship between two sections of your financial statements, usually over several periods of time, and give you an assessment of your business’s health. By using these ratios, you can uncover important trends in your business operations (or the operations of a competitor or potential investment), like whether you’ve accumulated too much debt, have too much inventory in stock or are not collecting payments fast enough.
Usually your DMCL advisor will be the one using these ratios to evaluate your business; however, it’s important to understand why they’re used and how they can raise a red flag if there’s signs of trouble. While there are many different financial ratios that are used by analysts, let’s look at some key ratios and how they can help you understand (and takes steps to improve) your business’s financial health.
These ratios serve as indicators of the long-term solvency of your business and can show you how much you are using long-term debt to support your business.
- Debt-to-equity ratio = Total liabilities / Shareholders’ equity: Measures how much debt is carried by your business compared to how much is invested by its owners. Bankers will watch this as an indicator of your business’s capacity to repay debts.
- Debt-to-asset ratio = Total liabilities / Total assets: Measures how much of your business’s assets are financed by creditors. If this ratio is high, it could signal your business has a large dependence on debt.
These ratios measure how much liquidity (cash and easily converted assets) your business has to cover debts, which can be used as an overview of its financial health.
- Quick (or ‘cash’) ratio = Liquid assets / Current liabilities: Demonstrates your business’s ability to pay creditors immediate demands with its most liquid assets. A ratio above 1.0 is acceptable; however, this can vary by industry.
- Current (or ‘working capital’) ratio = Current assets / Current liabilities: Demonstrates whether your business has enough cash flow to meet short-term obligations. A high ratio can help you take advantage of opportunities and favourable credit terms.
- Net profit margin = After tax profit / Net sales: You’re likely familiar with this ratio, which shows how much sales revenue your business keeps after its operating expenses, taxes and interest are paid.
- Return on equity = Net income / Shareholders’ equity: This ratio measures how much net income your business generates per dollar of equity (invested capital). The return on equity (ROE) percentage indicates to investors how efficiently your business uses its capital to generate profit.
- Returns on total assets = Income / Average total assets: This ratio simply measures how efficiently your business’s assets generate profit. It can indicate how well management is using the business’s resources.
- Accounts receivable turnover = Net sales / Average accounts receivable: This turnover ratio can help you understand how much money is tied up in accounts receivable, which indicates how quickly your customers are paying.
- Inventory turnover = Cost of goods sold / Average inventory: This is another ratio that helps measure how effectively your business is using its assets. It can help you make better pricing, manufacturing, marketing and purchasing decisions.
- Operating ratio = Operating expenses + cost of goods sold / Net sales: This ratio evaluates how efficiently a company manages its costs while generating revenue or sales. An operating ratio that is increasing is viewed negatively, as this indicates that your operating expenses are increasing relative to revenue or sales.
Reviewing financial ratios is a good way to run your business’s financial statements through regular check-ups to identify any areas that could use improvement, in addition to giving you the perspective of a potential financer or investor. Talk to your DMCL advisor if you have any questions about evaluating your business’s performance and they’ll be happy to make sure you have all the tools and knowledge you need to make financial decisions with clarity and confidence.
Visit the Business Development Bank of Canada’s financial tools page for more resources on financial ratios and how to use them.