Unlocking Wealth Using Financial Ratios in Decision-Making
This blog shows how Managers use performance metrics such as financial ratios in unlocking wealth in decision-making to evaluate past performance and make informed future choices. This comprehensive profitability analysis will introduce several ratios and decompositions that help decision-making. We will then analyze the drivers of operating profitability and demonstrate how ratios can be used to manage the business. Financial ratios leverage financial statements to assess the well-being of companies. Financial ratio analyses must become a critical tool in assessing companies.
What are financial ratios, and why are they essential for entrepreneurs to understand and use in their business ventures
Financial ratios analysis is a mathematical calculation that shows the relationships between different financial aspects of a company. Above all, ratios can be used to measure liquidity, solvency, profitability, and efficiency. They provide insights into a company’s performance and help entrepreneurs make informed decisions about their business ventures.
Entrepreneurs should know three main types of ratios: liquidity, profitability, and solvency.
Financial Ratio: Liquidity ratios
Liquidity ratios measure a company’s ability to pay its short-term debts. A business owner will use liquidity ratios to ensure that their company has enough cash to cover its expenses. To increase liquidity, a business owner may need to take out a loan, a working capital line of credit using the amount of inventory or accounts receivables held as collateral, or increase their sales to capture more cash or accounts receivables.
Critical liquidity ratios include:
The current ratio
The current ratio includes cash and other current assets considered liquid assets that can convert into cash within one year.
Current ratio = Current assets/current liabilities
The current ratio measures a company’s ability to pay its short-term debts with its existing assets. A high current ratio indicates that a company has a solid ability to pay its short-term obligations. Conversely, a low current ratio may tell that a company has difficulty paying its short-term debts.
Maintaining more short-term assets to cover short-term liabilities is critical and drives a positive current ratio.
The acid test or quick ratio
The acid-test or quick ratio excludes inventory and other assets that can’t be quickly converted into cash. This ratio measures a company’s ability to pay its short-term debts with its very liquid assets.
Quick ratio = (Cash + cash equivalents + marketable securities + accounts receivables)/Current liabilities
A high acid-test ratio indicates that a company has a solid ability to pay its short-term debts with its liquid assets. In contrast, a low acid-test ratio may suggest that a company has difficulty paying its short-term obligations with its liquid assets.
Maintaining sufficient receivables and cash levels drives a quick positive ratio.
Financial Ratio: Profitability ratios
Profitability ratios measure a company’s ability to generate profits. Overall, a business owner will use profitability ratios to ensure that their company generates enough revenue to cover its costs. Within this context, to increase profitability, a business owner may need to raise prices, reduce costs, or find new ways to generate revenue.
Critical profitability ratios include:
The gross margin ratio
The gross margin ratio measures the percentage of sales that a company keeps after paying for the cost of goods sold.
Gross profit margin = Gross profit/Sales
A high gross margin ratio indicates that a company keeps a large percentage of its sales after paying for the cost of goods sold. The gross margin may be due to low costs or high prices. Notwithstanding, a low gross margin ratio may indicate that a company is not keeping a large percentage of its sales after paying for the cost of goods sold. The low gross margin may be due to high costs or low prices.
Fair pricing and cost constraints are essential to achieving a higher gross profit margin.
The net operating profit margin ratio
The net operating profit margin ratio measures the percentage of sales that a company keeps after paying for its operating expenses.
Operating profit margin = Earnings before interest and taxes (EBIT)/Sales
A high net operating profit margin ratio indicates that a company keeps a large percentage of its sales after paying for all of its operating expenses. A high net operating profit margin may be due to low costs or high prices. On the other hand, a low net operating profit margin ratio may indicate that a company is not keeping a large percentage of its sales after paying for its operating expenses. A low net operating profit margin may be due to high costs or low prices.
Emphasizing sales drivers while managing cost controls enhances the prospects of making higher operating profit margins.
The net profit margin ratio
The net profit margin ratio measures the percentage of sales that a company keeps after paying for its expenses.
Net profit margin = Net income/Sales
A high net profit margin ratio indicates that a company keeps a large percentage of its sales after paying its expenses. The high-profit margin may be due to low costs, high prices, or both. Nevertheless, a low net profit margin ratio may indicate that a company is not keeping a large percentage of its sales after paying for its expenses. A low net profit margin may be due to high costs, low prices, or both.
The return on assets (ROA) ratio
The return on assets (ROA) ratio measures the percentage of profits a company generates from its assets.
Return on assets = Net income/Total assets
A high ROA ratio indicates that a company generates significant profits from its assets. The high ROA may be due to the efficient use of the company’s assets or high asset prices. However, a low ROA ratio may indicate that a company is not generating a large number of profits from its financial resources. The low ROA may be due to inefficient use of company resources or low asset prices.
The return on equity (ROE) ratio
The return on equity (ROE) ratio measures the percentage of profits a company generates from its shareholders’ equity.
Return on equity = Net income/Total shareholders’ equity
A high ROE ratio indicates that a company generates significant profits from its shareholders’ equity. The high ROE may be due to the efficient use of equity or high shareholder equity prices. Conversely, a low ROE ratio may indicate that a company is not generating sufficient profits from its shareholders’ equity. The low ROE may be due to inefficient use of equity or low shareholder equity prices.
Financial Ratio: Efficiency ratios
Efficiency ratios measure a company’s ability to generate sales from its assets. Business owners use efficiency ratios to assess how well their company uses its assets to generate sales.
Two critical efficiency ratios include:
Asset turnover ratios
The asset turnover ratio measures the number of sales that a company generates from its assets.
Asset turnover = Revenue/assets
A high asset turnover ratio indicates that a company generates large sales from its assets. The high asset turnover may be due to efficient use. A high turnover ratio also shows a higher ROA that may compensate for a low net profit margin.
The inventory turnover ratio
The inventory turnover ratio measures the number of times that a company’s inventory is sold and replaced during a period of time.
Inventory turnover = Sales/finished goods inventory
A high inventory turnover ratio indicates that a company is selling its inventory quickly. The high inventory turnover ratio may be due to high demand for the company’s products or efficient inventory management. In contrast, a low inventory turnover ratio may indicate that a company is not selling its inventory quickly. The low inventory turnover ratio may be due to low demand for the company’s products or inefficient inventory management.
Financial Ratio: Solvency ratios or leverage ratios
Solvency ratios measure a company’s ability to pay its long-term debts. A business owner will use solvency ratios to ensure that their company has enough assets to cover its liabilities. In other words, a business owner may need to take out a loan, sell assets, or find new ways to generate revenue to increase solvency.
Critical solvency ratios include:
The debt-to-asset ratio
The debt-to-asset ratio measures the percentage of a company’s assets financed by debt.
Debt-to-asset ratio = Total debt/Total assets
A high debt-to-asset ratio may indicate that a company is highly leveraged and may have difficulty paying its debts. Conversely, a low debt-to-asset ratio may suggest that a company is not highly leveraged and may have an easier time paying its debts.
The debt-to-equity ratio
The debt-to-equity ratio measures the percentage of a company’s equity financed by debt.
Debt-to-equity ratio = Total debt/The total shareholders’ equity
A high debt-to-equity ratio may indicate that a company is highly leveraged and may have difficulty paying its debts. Conversely, a low debt-to-equity ratio may indicate that a company is not highly leveraged and may have an easier time paying its debts.
The interest coverage ratio
The interest coverage ratio measures the ability of a company to make its interest payments.
Interest coverage ratio = Earnings before interest and taxes (EBIT)/Interest expense
A high-interest coverage ratio indicates that a company can make its interest payments. Conversely, a low-interest coverage ratio may suggest that a company cannot make its interest payments.
As you can see, there are a variety of financial ratios that entrepreneurs can use to evaluate their companies. each ratio provides different
Each type of ratio measures a different aspect of the business, so it’s essential to understand how each one works.
The most important thing to remember is that ratios are just one tool that you can use to make informed decisions about your business.
They should be alongside other information, such as sales data, customer surveys, and your observations about the business.
When used correctly, financial ratios can be a helpful tool for entrepreneurs of all experience levels.
Do you use financial ratios in your business? What ratios do you find to be the most helpful?
Ratios can help entrepreneurs make better decisions
If you’re not using ratios in your decision-making process, you may want to start! They could just be the thing that takes your business to the next level.
Thanks for reading! I hope this post was helpful in understanding how financial ratios can help entrepreneurs make better decisions. If you have any questions, feel free to leave a comment below.
Entrepreneurs can make their businesses more successful and profitable by using financial ratios!
If you want to learn more about financial ratios and how to use them in your business, check out this course on performance management.
By taking this course, you’ll be able to:
- Understand what financial ratios are and how they can be used
- Calculate important financial ratios for your business
- Analyze your company’s financial performance
- Understand how to use ratios to make informed decisions about pricing, hiring, and investing
So what are you waiting for?
As you can see, there are a variety of financial ratios that entrepreneurs can use to evaluate their companies.
In summary
Above all, you can use financial ratios to address crucial strategic and tactical challenges without delving into arcane business analysis. Importantly, by understanding and using performance metrics, such as financial ratios, you can make informed future choices for your company. This blog introduced several ratios and decompositions that help in decision-making. We then analyzed the drivers of operating profitability and demonstrated how ratios could help you manage the business.
FAQs
Q: What is a debt-to-equity ratio?
A: The debt-to-equity ratio measures the amount of a company’s equity that is financed by debt. A high debt-to-equity ratio may indicate that a company is highly leveraged and may have difficulty paying its debts. Conversely, a low debt-to-equity ratio may indicate that a company is not highly leveraged and may have an easier time paying its debts.
Q: What is an interest coverage ratio?
A: The interest coverage ratio measures the ability of a company to make its interest payments. A high-interest coverage ratio indicates that a company can make its interest payments. Conversely, a low-interest coverage ratio indicates that a company may have difficulty making its interest payments.
Q: What is a current ratio?
A: The current ratio measures the ability of a company to pay its short-term debts. A high current ratio indicates that a company can pay its short-term obligations. Conversely, a low current ratio indicates that a company may have difficulty paying its short-term obligations.
By taking this course, you’ll be able to understand and calculate different types of financial ratios that can help you make informed decisions about your business. Enroll today and start using performance metrics to improve your business! Thanks for reading.