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.