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What Are 'Financial Ratios'?

Financial Ratios are beneficial because they allow you to make comparisons very quickly. Financial Ratios are useful for sanity-checking profit, debt, cash, and efficiency without spending too much time.

Every business has a small number of important ratios to consider, so it’s worthwhile to do a bit of research to see what they are for your industry.

Josh Kaufman Explains 'Financial Ratios'

Once you’ve compiled your business’ basic financial reports, you can examine them in many different ways. One of the most effective strategies is to calculate a Financial Ratio: a comparison of two important elements of your business.

Financial Ratios are beneficial because they allow you to make comparisons very quickly. Instead of poring through the data in the financial reports manually, looking at a Financial Ratio helps you decide whether or not certain parts of the business are healthy at a glance. Looking at how these ratios change over time helps you see how the business is changing over time. Comparing the ratios to industry averages makes it easy to see if the company is performing like a typical company in the industry, or if something is odd.

Profitability ratios indicate a business’ ability to generate Profit. The higher your revenue and the lower your costs, the higher your profitability ratios. We’ve already discussed Profit Margin, which is a very basic profitability ratio. “Return on Assets,” which is calculated by dividing net profit by total assets, tells you what percentage of every dollar invested in the business was returned as profit.

Leverage ratios indicate how your company uses debt. “Debt-to-Equity” ratios, which are calculated by dividing total liabilities by shareholder’s equity, tell you how many dollars a company has borrowed for every $1 in owner’s equity. If the ratio is high, it’s a signal the company is highly Leveraged, which could be a bad sign. Other ratios, like “Interest Coverage,” calculate how of the business’ profit goes to pay off interest on debt.

Liquidity ratios indicate the ability of a business to pay its bills. Running out of cash is a serious issue, so ratios like the “Current Ratio” (current assets divided by current liabilities) and the “Quick Ratio” (current assets minus inventory divided by current liabilities) make it easy to determine how close a company is to bankruptcy, or if the business is sitting on cash instead of invest money in growth or improvement.

Efficiency ratios indicate how well a business is managing assets and liabilities. The most common use is inventory management: having too little inventory is a bad thing, but having too much is also bad. Calculating the average number of days an item is in inventory, how long it takes to sell out current inventory, and “Day Sales Outstanding,” a measure of how long it takes to collect the cash from sales, are helpful when making changes that can production, capital purchases, and

There are thousands of different types of Financial Ratios, and covering them all is way beyond the scope of this book. Financial analysts tend to choose a small set of important ratios based on the industry: it makes no sense to calculate “inventory turns” for a barbershop.

Every business has a small number of important ratios to consider, it’s worthwhile to do a bit of research to see what they are for your industry.

Questions About 'Financial Ratios'

• Which financial ratios are most important for your business?
• Which ratios are important in your industry?

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"In the real world, the tests are all open book, and your success is inexorably determined by the lessons you glean from the free market."

Jonathan Rosenberg, former senior vice president of product management at Google

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