Accounting and finance ratios are a quick way to review and evaluate financial information. The four major types of ratios used in the industry are Liquidity (aka solvency), Activity (aka efficiency), Profitability, and Coverage. They are vital for management to evaluate the operations of their business and determine if certain management actions are having an effect on the “numbers”. Ratios can also be used by owners and readers of financial statements to quickly identify the health of the company, unusual trends in the business, and certain key indicators of the business. Below are some of the most popular ratios that people use to evaluate financial statements:
Gross profit margin – Sales less cost of sales divided by Sales. This ratio is one of the most important ratios of a business. It measures whether the company is profitable when selling its products/services (reviews the sales against the direct costs to make / provide services).
Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) – This is not necessarily a ratio but an excellent value used to evaluate the financial performance of a company. It is also widely used as measure of earnings potential of a business. Sometimes it is used as a quick measure of net cash activity, but is imperfect when used this way and shouldn’t replace actually looking at operating cash flow on the cash flow statement.
The fixed charge coverage ratio is widely used by banks to calculate covenants. It measures a company’s ability to calculate its current debt and interest. There are a couple different variations of the calculation, but typically it takes EBITDA divided by current year debt obligations plus interest.
Accounts receivable turnover – Total sales divided by average accounts receivable. This ratio gives the reader an estimate of how often accounts receivable is collected each year.
Inventory turnover – Total cost of sales divided by average inventory. This ratio gives the reader an estimate of many times a year they turn (sell) their inventory balance.
Current Ratio – Current assets divided by current liabilities. This ratio generally speaks to the health of the company by showing how many times the company can pay its current liabilities due within one year with its current assets.
These are just a few of the many ratios that a reader of a financial statement can use to measure the strengths and weaknesses of a business. There are many differing opinions on which ones are the best to use, but remember, everyone looks at a statement differently. You just need to find out the couple that are important to you.
