Financial Ratios: An Objective Way to Measure Business Performance

Accounts Receivable Turnover

This ratio measures how your company is managing collections.

Net Annual Credit Sales / Average Accounts Receivable

A higher rate means your customers are paying their bills quickly.

Current Ratio

This liquidity ratio provides stakeholders with information regarding a company's ability to meet its short-term financial obligations. It is used by creditors and lenders when credit needs to be extended.

Current Assets / Current Liabilities

The higher the ratio, the more likely the company can timely pay off its obligations.

Cash Flow Margin

This ratio helps show the relationship between cash generated by operations and sales. It is a trusted metric of a company's profitability and efficiency as well as earnings quality.

Operating Cash Flow / Net Sales

The higher the percentage, the more ability you have to convert sales to cash flow.

Days Payable Outstanding (DPO)

This ratio indicates how well the company is managing cash flow. It shows the average time it takes to pay bills and invoices to creditors.

Days Payable Outstanding = Average Accounts Payable / Cost of Goods Sold x Number of Days in the Accounting Period

Average Accounts Payable = Accounts Payable Balance at the Beginning of the Period - Ending Accounts Payable Balance / 2

A higher DPO indicates a longer time to pay bills which can be advantageous if the company is using the funds until they are due to creditors. However, a high DPO could also be a red flag that the company is unable to pay bills on time.

Debt Service Ratio

This ratio indicates the ability to repay all debt obligations with operating income. Debt ratios indicate solvency as it measures total liabilities as a percentage of total assets. Essentially, this ratio indicates the ability to pay off liabilities with assets.

Total Debt / Total Assets

A lower debt ratio indicates a more stable business. Each industry has its own benchmarks for debt, but .5 is considered reasonable as it indicates that the liabilities are only 50% of total assets. This means that creditors only own half of the company assets and the shareholders own the other half.

Gross Profit Margin

Indicates how much of your revenue is profit after expenses are subtracted. It should be large enough to cover your fixed (operating) expenses. This is an indicator of how good a company is at creating a service compared to the competition.

Net Sales - Cost of Goods Sold / Net Sales

Without an adequate gross margin, a company cannot pay for its operating expenses. In general, a company's gross profit margin should be stable unless there have been changes to the company's business model.

Inventory Turnover Ratio

This ratio is a measure of how the company is generating sales from their inventory.

Cost of Goods Sold / Average Inventory

A high turnover rate could indicate an inadequate inventory level, resulting in stock shortages. A low turnover rate may indicate overstocking.

Liquidity Ratio

This ratio indicates the company's ability to repay short-term creditors with available cash.

Liquid Assets / Short-Term Liabilities

If the ratio is greater than 1.0, your cash on hand will cover the short-term liabilities.

Net Profit Margin

The percentage of revenue left after all expenses have been deducted from sales. The measurement reveals the amount of profit that a business can extract from its total sales. The net sales part of the equation is gross sales minus all sales deductions, such as sales allowances.

Net Profit / Net Sales

A high net profit margin indicates that a business is pricing its products correctly and exercising good cost control. Generally, a net profit margin in excess of 10% is considered excellent, though it depends on the industry and the structure of the business.

Operating Margin

This ratio measures how profitable the company is from its operations.

Operating Income / Revenue

If your operating margin is 0.5, it indicates that there is $0.50 in profit for every dollar of revenue. This ratio does not account for non-operational expenses; it should not be used alone.

Quick Ratio

The quick ratio measures the ability to use quick assets to cover current liabilities.

(Cash and Cash Equivalents = Marketable Securities + Accounts Receivable) / Current Liabilities

A company with a ratio less than 1.0 cannot quickly pay back its current liabilities.

Return on Total Assets

This ratio shows the company's net profit in relation to its assets value.

Net Income / Average Total Assets

The ratio is often used by financial institutions when considering a loan for your company. It indicates how effectively the company uses the money to secure assets.