Financial Ratios Improve Decision-Making

Making sound and timely business decisions is critical to any organization’s success. By understanding and using performance metrics, such as financial ratios, you can make informed future choices for your company. Financial ratios are needed if you want to perform a business transition. In this article, we introduced several ratios and decompositions that help in decision-making. We then analyzed the drivers of operating profitability and demonstrated how ratios could help manage the business. You can develop financial models and control them as well as measure performance with financial ratios. Even using a single financial ratio can help you in decision-making.

This article shows you the drivers of operating profitability and demonstrates how financial ratios can be used to manage your company and the importance of knowing how to read financial statements. Using financial ratios allows you to perform a successful business transformation.

What are financial ratios and why are they important for entrepreneurs to understand and use in their business ventures

Financial ratios are mathematical calculations that show the relationships between different financial aspects of a company. Such ratios allow for the measurement of liquidity, solvency, profitability, efficiency, and valuation.

Different stakeholders use certain financial ratios in making different types of decisions. For example, in the area of corporate finance, lenders may use financial ratios to decide whether to provide a loan to a company and what the terms of that loan should be. Investors may use financial ratios to decide whether to invest in a company and at what price. Management may use financial ratios to make operational decisions, such as whether to expand production or reduce costs.

Overall, financial ratios provide insights into a company’s performance and help entrepreneurs make informed decisions about their business ventures.

Four main types of financial ratios exist that entrepreneurs should be aware of liquidity, profitability, solvency, and efficiency

Liquidity ratios

Liquidity ratios measure a company’s ability to pay its short-term debts. A business owner will use liquidity ratios to make sure that their company has enough cash on hand 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 both cash and other assets that can be quickly converted into cash, such as marketable securities within one year.

The liquidity ratio measures a company’s ability to pay its short-term debts with its current assets. A high current ratio indicates that a company has a strong ability to pay its short-term debts. Conversely, a low current ratio may indicate that a company is having difficulty paying its short-term debts.

The acid test or quick ratio

The acid-test or quick ratio excludes inventory and other assets (more illiquid than cash and receivables). This ratio measures a company’s ability to pay its short-term debts with its liquid assets.

A high acid-test ratio indicates that a company has a strong ability to pay its short-term debts with its liquid assets. Conversely, a low acid-test ratio may indicate that a company is having difficulty paying its short-term debts with its liquid assets.

Profitability ratios

Profitability ratios measure a company’s ability to generate profits. Overall, a business owner will use profitability ratios to make sure that their company is generating enough revenue to cover its costs. Within this context, to increase profitability, a business owner may need to increase prices, reduce costs, or find new ways to generate revenue. Critical profitability ratios (activity ratios) include:

The gross margin ratio

The gross margin ratio (gross profit margin ratio) measures the percentage of sales from gross profits that a company keeps after paying for the cost of goods sold. The cost of sales includes the direct costs of producing a product or providing a service, such as the cost of the materials used or the wages paid to employees who work directly on the product or service. It also includes indirect costs, such as the cost of heating or lighting a factory that produces a product. The gross profit margin determines the excess earnings covering the cost of sales.

A high gross margin ratio indicates that a company is keeping a large percentage of its sales after paying for the cost of goods sold. This may be due to low costs or high prices. Conversely, 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. This may be due to high costs or low prices.

The net operating profit margin ratio

The net operating profit margin ratio measures the percentage of sales that a company keeps after paying for all of its operating expenses. The ratio determines the efficiency growth in earning.

A high net operating profit margin ratio indicates that a company is keeping a large percentage of its sales after paying for all of its operating expenses. This may be due to low costs or high prices. Conversely, a low net operating profit margin ratio may indicate that a company is not keeping a large percentage of its sales after paying for all of its operating expenses. This may be due to high costs or low prices.

The net profit margin ratio

The net profit margin ratio measures the percentage of sales that a company keeps after paying for all of its expenses.

A high net profit margin ratio indicates that a company is keeping a large percentage of its sales after paying for all of its expenses. This may be due to low costs, high prices, or a combination of both. Conversely, a low net profit margin ratio may indicate that a company is not keeping a large percentage of its sales after paying for all of its expenses. This may be due to high costs, low prices, or a combination of both.

The Cash flow margin

The cash flow margin measures the percentage of sales that a company keeps after paying for all of its expenses and reinvesting in the business. A high cash flow margin indicates that a company is keeping a large percentage of its sales after paying for all of its expenses and reinvesting in the business. Conversely, a low cash flow margin may indicate that a company is not keeping a large percentage of its sales after paying for all of its expenses and reinvesting in the business.

The return on assets (ROA) ratio

The return on assets (ROA) ratio measures the percentage of profits that a company generates from its assets.

A high ROA ratio indicates that a company is generating a large amount of profits from its assets.

This may be due to the efficient use of assets or high asset prices. Conversely, a low ROA ratio may indicate that a company is not generating a large amount of profits from its assets. This may be due to inefficient use of assets or low asset prices.

The return on equity (ROE) ratio

The return on equity (ROE) ratio measures the percentage of profits that a company generates from its shareholders’ equity.

A high ROE ratio indicates that a company is generating a large amount of profits from its shareholders’ equity. This 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 a large amount of profits from its shareholders’ equity. This may be due to inefficient use of equity or low shareholder equity prices.

Efficiency ratios

https://www.businessinsider.com/personal-finance/return-on-assetsmeasure a company’s ability to generate sales from its assets. Business owners use efficiency ratios to assess how well their company is using its assets to generate sales. Two critical efficiency ratios include:

Asset turnover ratios

The asset turnover ratio measures the amount of sales that a company generates from its assets.

A high asset turnover ratio indicates that a company is generating a large amount of sales from its assets. This may be due to efficient use

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.

A high inventory turnover ratio indicates that a company is selling its inventory quickly. This may be due to high demand for the company’s products or efficient inventory management.

Conversely, a low inventory turnover ratio may indicate that a company is not selling its inventory quickly. This may be due to low demand for the company’s products or inefficient inventory management.

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 make sure that their company has enough assets to cover its liabilities. To increase solvency, a business owner may need to take out a loan, sell assets, or find new ways to generate revenue. Critical solvency ratios include:

The debt-to-asset ratio

The debt-to-asset ratio measures the percentage of a company’s assets that are financed by debt.

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 indicate 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 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.

The interest coverage ratio

The interest coverage ratio measures the ability of a company to make its interest payments.

A high-interest coverage ratio indicates that a company is able to make its interest payments. Conversely, a low-interest coverage ratio may indicate that a company is not able to make its interest payments.

The cash flow to fixed charges ratio

The cash flow to fixed charges ratio measures the ability of a company to make its fixed payments. A high cash flow to fixed charges ratio indicates that a company is able to make its fixed payments. Conversely, a low cash flow to fixed charges ratio may indicate that a company is not able to make its fixed payments.

The cash flow to interest coverage ratio

The cash flow to interest coverage ratio measures the ability of a company to make its interest payments. A high-cash flow to interest coverage ratio indicates that a company is able to make its interest payments. Conversely, a low-cash flow to interest coverage ratio may indicate that a company is not able to make its interest payments.

The business valuations ratios

When a business is being sold, the buyer will often use financial ratios to get a better understanding of the company’s financial health. Different valuation methods exist, including the use of ratios. By looking at a company’s financial ratios, the buyer can get an idea of how risky it is to buy the company. Thus, the buyer can also use financial ratios to determine how much they should pay for the company or the fair market value.

Offering price-to-sales ratio

The offering price-to-sales ratio (OPSR) is used to value a private business by comparing the previous acquisitions. The OPSR is calculated by dividing the business’s current offering price by its most recent twelve months’ sales. This ratio will give you an idea of how much the market is willing to pay for a company’s revenue.

To value a private business, the buyer will compare the OPSR to the ratios of similar businesses that have been acquired in the past. If the OPSR is higher than the ratios of similar businesses, then the buyer will likely pay more for the company. Conversely, if the OPSR is lower than the ratios of similar businesses, then the buyer will likely pay less for the company.

Intrinsic financial ratios

There are a few intrinsic financial ratio metrics that can be used to value a private business. including:

• The earnings before interest and taxes (EBIT) to enterprise value (EV)
• The free cash flow to EV
• The EBITDA to EV ratios

These intrinsic financial ratios measure cash flows to Enterprise Value (EV). The enterprise value is the total value of a company. This metric is used to determine the value of a company in comparison to its peers.

The EBIT to enterprise value ratio

The EBIT to EV ratio is a measure of a company’s profitability. It is calculated by dividing a company’s EBIT (earnings before interest and taxes) by its EV. To calculate EBIT start with net income and add back, provision from income taxes and interest expenses.

The EBIT to EV ratio is important because it gives investors an idea of how profitable a company is. A high EBIT to EV ratio means that a company is making a lot of money, while a low EBIT to EV ratio means that a company is not making very much money.

The EBITDA to enterprise value ratio

The EBITDA to enterprise value ratio is a measure of a company’s profitability. It is calculated by dividing a company’s EBITDA by its EV. EBITDA is earnings before interest, taxes, depreciation, and amortization. This metric measures a company’s cash flow efficiencies to the enterprise value. This metric is used to determine the value of a company in comparison to its peers.

The EBITDA to EV ratio is important because it gives investors an idea of how profitable a company is. A high EBITDA to EV ratio means that a company is making a lot of money, while a low EBITDA to EV ratio means that a company is not making very much money.

Free cash flow to enterprise value ratio

The free cash flow to enterprise value (FCF/EV) ratio is a measure of a company’s financial health. This ratio measures the amount of free cash flow a company has relative to its enterprise value.

A high FCF/EV ratio indicates that a company is healthy and has a lot of free cash flow. Conversely, a low FCF/EV ratio indicates that a company is not healthy and does not have a lot of free cash flow.

The FCF/EV ratio can be used to value a private business by comparing it to the ratios of similar businesses that have been acquired in the past. If the FCF/EV ratio is higher than the ratios of similar businesses, then the buyer will likely pay more for the company. Conversely, if the FCF/EV ratio is lower than the ratios of similar businesses, then the buyer will likely pay less for the company.

Each type of ratio measures a different aspect of the business, so it’s important 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 used alongside other information, such as sales data, customer surveys, and your own 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 when it comes to things like pricing products, hiring employees, and investing money

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,

By using financial ratios, entrepreneurs can make their businesses more successful and profitable!

If you want to learn more about financial ratios and how to use them in your business, check out this course on reading financial statements.

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

As you can see, there are a variety of financial ratios that entrepreneurs can use to evaluate their companies.

In summary

In the end, making sound and timely business decisions is critical to the success of any organization. By understanding the financial statements and using performance metrics, such as financial ratios, you can make informed future choices for your company. This article introduced several ratios and decompositions that help in decision-making. You can analyze the drivers of operating profitability, operational effectiveness, and value creation attributes. Additionally, this article demonstrates ratios use help in managing the business and enable financial models in building projections. Did you find this article helpful? What are some things you would like us to cover in a future post? Let us know in the comments below!

So what are you waiting for? Enroll in the course today and start using financial ratios to improve your business! Thanks for reading.

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 is able to 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 is able to pay its short-term debts. Conversely, a low current ratio indicates that a company may have difficulty paying its short-term debts.

Q: What is a debt-to-equity ratio?

A: The debt-to-equity ratio measures a company’s equity that is financed by debt. A high debt-to-equity ratio indicates that a company is highly leveraged and may have difficulty paying its debts. Conversely, a low debt-to-equity ratio indicates 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 is able to make its interest payments. Conversely, a low-interest coverage ratio indicates that a company may have difficulty making its interest payments.