Numbers tell a story. We already know that: we're all experienced data-driven storytellers here.
But raw data, even after it's been summarized in your reports, does not a full story make. Like the words of a novel, you'll get more out of the values you report on when you start putting them together in new and meaningful ways.
That's where financial ratios come in.
By tracking changes over time, your financial ratios enable you:
So what are the ratios you should be paying attention to--and what plot twists will they add to the story your reporting tells? Let's take a look, but first, let's look at a definition of financial ratios.
Financial ratios enable you to perform quantitative analysis to understand your organization better. There's an entire list of financial ratios you can draw from to better tell the story of your business--all of them falling under one of five main categories.
Profitability ratios determine your organizations ability to generate profit relative to revenue, operating costs, balance sheet assets and shareholder equity.
Measure your company's ability to pay off its current debt without raising extra capital.
Calculate how well your business manages its assets and liabilities internally, these help track the financial health of your organization.
Determine how much of your organization's capital is assumed through debt and evaluate how reliant you are on debt for growth.
Calculate your publicly held company's current share price, helping investors evaluate whether those shares are overpriced or underpriced.
Each category incorporates a range of different ratios designed to help finance teams, like yours, get to the information needed, and for investors and analysts to better understand the health of your business. Together, these ratios can begin to offer a fuller picture of your company's performance.
The most popular financial ratios aren't necessarily complicated to compute--in fact, what are often deceptively simple calculations can offer a wealth of meaningful information. Just look at these examples:
|
Financial Ratio |
Example |
Formula |
Use Cases |
Profitability Ratio Examples |
Profit Margin |
Gross Profit Margin = Gross Income / Revenue Operating Profit Margin = Operating Income / Revenue Net Profit Margin = Net Income / Revenue |
By demonstrating what percentage of sales has turned into profits, your Profit Margin showcases the degree to which a business activity makes money. The numbers you plug in will vary depending on the type of profit margin being measured (i.e., Gross Profit Margin, Operating Profit Margin, Net Profit Margin). |
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Return On Assets (ROA) |
ROA = Net Income / Average Total Assets |
ROA measures your company's efficiency in generating earnings from assets by showcasing how much profit your company can gain from those assets. |
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Return On Equity (ROE) |
ROE = Annual Net Income / Shareholders' Equity |
ROE demonstrates how well your organization is handling shareholder contributions. It measures the profitability of your organization as it relates to stockholders' equity. |
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Liquidity Ratio Examples |
Current Ratio |
Current Ratio = Current Assets / Current Liabilities |
By looking at current assets in relation to current liabilities, your Current Ratio helps investors better understand your organization's ability to pay off short-term debt obligations. |
|
Quick Ratio |
Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities |
By examining how easily your organization can use near-cash assets to pay down its current liabilities, your Quick Ratio measures your organization's ability to meet its short-term debt obligations using its most liquid assets. |
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Days Sales Outstanding (DSO) |
DSO = (Accounts Receivable / Net Credit Sales) x Number of Days |
Your DSO provides valuable information on your cash conversion cycle by measuring the average number of days it takes for your business to collect payment from a sale. |
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Efficiency Ratio Examples |
Asset Turnover Ratio |
Asset Turnover Ratio = Net Sales / Average Total Assets |
The Asset Turnover Ratio demonstrates how efficient your company is at using assets to generate revenue. It examines the value of your company's sales or revenue in relation to the value of its assets. |
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Inventory Turnover Ratio |
Inventory Turnover = Cost of Goods Sold / Average Inventory |
By measuring how often a company has replaced inventory during a specified period, the Inventory Turnover Ratio helps you better determine pricing and know when to purchase new inventory. |
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Receivables Turnover Ratio |
Receivables Turnover = Net Credit Sales / Average Accounts Receivable |
By measuring your business's ability to collect the money you owe, your Receivables Turnover Ratio helps investors and analysts understand how quickly your short-term debt is collected and paid. |
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Leverage Ratio Examples |
Debt Ratio |
Debt Ratio = Total Debt / Total Assets |
Your Debt Ratio measures the ratio of total debt to total assets, which determines the extent of your business's leverage or the percentage of assets financed by debt. |
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Debt-to-Equity (D/E) Ratio |
D/E = Total Liabilities / Total Shareholders' Equity |
By calculating how well shareholder equity can cover outstanding debt, your D/E Ratio helps determine how much of your business is financed through debt--and how prepared you are for a crisis. |
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Interest Coverage Ratio |
Interest Coverage = Earnings Before Interest and Taxes (EBIT) / Interest Expense |
Your Interest Coverage Ratio lets creditors, investors and analysts know whether your company is a good risk for future lending by measuring how easily your organization can pay interest on its outstanding debt. |
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Debt-Service Coverage Ratio (DSCR) |
DSCR = Net Operating Income / Debt Service |
By looking at the cash flow your organization has available to pay your existing debt obligations, your DSCR lets investors know whether you have the income available to pay off your debts. |
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Market Value Ratio Examples |
Book Value Per Share (BVPS) Ratio |
BVPS = (Shareholders' Equity - Preferred Stock) / Average Shares Outstanding |
Your BVPS Ratio helps investors evaluate your business's stock price by measuring the ratio between your shareholders' equity and outstanding shares. |
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Dividend Yield Ratio |
Dividend Yield = Annual Dividends Per Share / Current Share Price |
By calculating, in the form of a percentage, how much your business pays out annually in dividends in relation to its stock price, the Dividend Yield Ratio enables investors to calculate how much they'll earn from dividends. |
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Earnings Per Share (EPS) Ratio |
Earnings Per Share = (Net Income - Preferred Dividends) / Average Shares Outstanding |
By looking at your company's profit in relation to outstanding shares, your EPS Ratio lets you and your investors know how much money your company earns from each share of its stock, helping to create an estimate of your overall organizational value. |
If you're a finance professional tasked with reporting, you're probably using financial ratios in some capacity already--and it's exactly because they are so widely used that they're so useful.
Financial ratios provide a common language. By trending your ratios over time, you and your investors can compare your company's performance from one period to another, and against market norms and competitors. And by using the reported values already available in three key financial statements - balance sheet, income statement and cash flow statement, ratios also provide a relatively quick way to analyze your financial health.
The richest stories come not from using a single financial ratio, though, but rather by applying a mix of ratios and using them alongside the other information available to you such as modeling. That might include insights from your KPI dashboards or the information you gather from non-financial metrics across sales, marketing, operations and the rest of your organization. Either way, in doing so, you'll reveal truths about your company's performance--as well as the potential value your business might have for investors, creditors and lenders.