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There are many different types of financial ratios that can give insights into a company’s financial performance, strengths, and weaknesses by taking different items from the income statement, balance sheet, and cash flow statements. Financial ratios measure a company’s operational efficiency, profitability, and liquidity. Different financial ratios are designed for different purposes; however, the following financial ratios are essential and should be understood and included in every financial analysis of a company.
“We expect all our businesses to have a positive impact on our top and bottom lines... Profitability is very important to us, or we wouldn't be in this business.” ― Jeff Bezos
Every business needs to generate profits, period. Profits are the result of deducting expenses and costs from revenues. In other words, the lower the cost, the more cost-effective the company is, the higher the profits, and the higher return to investors. Therefore, to better understand the quality of profitability, it needs to be measured by considering its relation to revenue, costs, expenses, assets, and equities.
- Gross profit margin: measures gross profit as a percentage of revenue
- EBITDA margin: measures operating income as a percentage of revenue
- Operating margin: measures operating income as a percentage of revenue before deducting non-operating or non-core income statement items
- Net profit margin: measures net income as a percentage of revenue
- Return on assets: measures how efficiently the assets operate by profitability dividing total assets
- Return on equity(ROE): calculates the return to shareholders.
It’s important to observe how profitability ratios change over time and within the same period. More digging is definitely required if any profit margin is unusually high or low. Any one-time and non-core operation-related items must be identified and normalized.
A word of caution: profitability does not mean cash! A company could generate high profits on paper but cannot meet its liabilities. Please refer to “Key Factors to Measure the Success of a Company” blog post.
Debt is a great financial instrument to finance a company’s growth and operations and increase returns to shareholders. However, debt is a double-edged sword that can hurt a company. Lenders don’t share borrowers’ profits or losses. Their intention is to get the loan paid back with interest. This is especially important for capital-intensive companies which depend on debt to invest in CAPEX and future growth. Some of the most important leverage ratios are:
- Debt-to-Equity: measures the financial leverage as a percentage of a company’s operation financed by debt.
- Total-Debt-to-Capitalization: provides an overview of a company’s financial structure. The higher the debt-to-capitalization ratio, the higher the leverage and the riskier the company. It’s calculated by interest-bearing debt dividing total capital (total interest-bearing debt + Shareholders’ equity).
- Interest Coverage Ratio: takes profitability into account and measures how well a company can pay for its interest expense on its outstanding debt. This ratio is part of the borrower’s ability to pay analysis for lenders.
“Revenue is vanity, profit is sanity, but cash is king.”
Do not confuse profitability with cash, especially when a company’s revenue is made up mostly of credit sales with large account receivables. There are also ways to increase profitability without actually increasing cash which is beyond the scope of this blog. That being said, an important measurement of the health of a company is its liquidity ratios. The following liquidity ratios are extremely important and apply to all industries.
- Current ratio: measures a company’s ability to pay for its short-term obligations. It measures the company’s ability to meet its short-term obligations.
- Quick ratio: calculated by dividing the most liquid assets such as cash and cash equivalents, short-term marketable securities, and account receivables by total current liabilities. The higher the ratio, the healthier the company’s short-term financial standing.
- Days of sales outstanding: measures the number of days for a company to receive cash for a sale. Days of sales outstanding is a very useful measurement to compare with the same period revenue growth rate. If the revenue grew exceptionally well with increasing days of sales outstanding, more digging is required to get a full picture of the quality of the revenue and the company’s strategy.
These are some of the most important financial ratios that every analysis should have. The pre-requisite of accurate financial ratios is a complete financial statements projection analysis with complete and integrated income statement, balance sheet, and cash flow statements. The process of building a dynamic financial projection analysis model with Excel is very error-prone and time-consuming. PRJ Analytics is a cloud-based financial projection application without using Excel or writing a single line of formula. Visit our site to learn more.