Numbers are critical in helping you understand your business’s financial health. One of the effective ways to utilize numbers to gain this understanding and make better decisions is through the use of financial ratios.

Financial ratios are numerical values obtained from your company’s financial statements which help you to understand the profitability, solvency, efficiency, and liquidity of your business.

Here in this article, we will look into the definition, importance, types of financial ratios, and best practices to enhance business decisions using the data generated from your financial ratio.

Definition of Financial Ratio

Financial ratios are numerical values derived from a company’s financial statement, that are used to evaluate a company’s operational efficiency, solvency, liquidity, and profitability. In simpler terms, they can be defined as numbers that show a relationship between two financial figures obtained from a company’s financial statement that help you to understand the different aspects of your company, such as how profitable it is, how well it can pay its debts, or how efficiently it uses its resources.

Importance of Financial Ratios in Understanding Business Performance

Here are some of the key importance of financial ratios in conducting and understanding business performance appraisal:

  • Performance Assessment: Financial ratios help the management and the stakeholders of a company gain insight into the company’s profitability, how well it is managing its operations, and its ability to settle its obligations on time.

By comparing ratios over a specific period, you can easily identify trends, track the company’s progress, and measure improvements or declines in performance.

  • Benchmarking: You can use financial ratios to run comparisons with industry standards or competitors to identify areas where your company needs to improve.
  • Decision-Making: Financial ratios represent clear and quantifiable data and metrics upon which strategic business decisions regarding investments, financing, and operations can be based. By providing insights into key financial issues affecting a business and the underlying factors responsible for a business’s performance, ratios prove to be valuable tools to aid the identification of key result areas a business needs to focus on.
Types of Ratios and Examples

The four main types of financial ratios include profitability ratios, liquidity ratios, solvency ratios, and activity ratios. Let’s look at what each of these ratios entails and their examples.

1.      Profitability Ratios

Profitability ratios are the specific types of ratios that measure your company’s ability to generate profit relative to its equity, assets, or revenue. They show how well a company is managing its expenses and generating earnings. Examples are:

  • Gross Margin: This refers to the percentage of profit remaining after deducting the direct costs i.e. cost of sales.
  • Profit Before Tax Margin: This measures the percentage of profit that remains after all direct and indirect expenses have been deducted, but before taxes.

2.      Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its short-term functions using its short term assets, called current assets. These ratios provide insights into understanding the short-term financial stability of a business. They include:

  • Current Ratio: This ratio measures the company’s ability to pay short-term commitments with its current assets.
  • Quick (Acid-Test) Ratio: This assesses the ability of the company to cover short-term liabilities with its most liquid assets.

3.      Solvency/Leverage Ratios

Solvency ratios evaluate the company’s capacity to meet its long-term responsibilities and effectively manage its debt. This gives you insight into the long-term financial stability and risk of your company.

  • Debt-to-Equity Ratio: This assesses the relative proportion between the shareholders’ equity and debt used to finance the company’s assets.
  • Interest Coverage Ratio: This measures the percentage of how easily a company can service or pay interest on outstanding debt.

4.      Activity/Efficiency Ratios

Activity ratios are specific ratios that assess the company’s ability to utilize its assets to generate revenue and manage its working capital. Activity ratios measure the operational efficiency of a company.

  • Inventory Turnover Ratio: This indicates the number of times inventory is sold and replaced over a period.
  • Assets Turnover Ratio: This assesses how efficiently a company uses its assets to generate revenue.
  • Debtors Collection Period: This indicates the average number of days it takes to collect payments from customers.
Interpretation of Ratios

You do not stop at identifying and calculating ratios. You have to learn to interpret them. It is in the interpretation that you gain meaningful insights into your company’s performance and financial health and make decisions. Let’s look at some ways you can interpret your ratios.

1.      Comparison with Industry Standard

Comparing your financial ratio with industry averages helps you identify strengths and weaknesses relative to competitors. For example:

  • Profitability Ratios: If your company’s gross margin is significantly higher than the industry average, it entails that you have a competitive advantage in production efficiency or pricing strategy.
  • Liquidity Ratios: If your company’s current ratio is much lower than the industry average, it indicates liquidity issues, which means you need to top up your working capital management strategy.
  • Solvency Ratios: If your debt-to-equity ratio is higher than the industry average, it indicates higher financial risk; hence, there will be a need to review the company’s capital structure to remediate it before it becomes critical.
  • Activity/ Efficiency Ratios: An inventory turnover ratio that is lower than the industry standard shows that your inventory is overstocked or slow-moving, which means you need to improve your inventory management practices.

2. Past Performance of the Business

Analyzing your financial ratios helps you gain an understanding of your business performance trajectory. This helps you to identify patterns and set benchmarks. By identifying patterns, you can anticipate and plan for future challenges and opportunities.  Also, historical ratios provide a baseline for measuring progress and setting plans. It is a necessity in planning.

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Trend analysis can provide insight on:

  • Improvements: When there is a consistent increase in profitability ratios, such as net profit margin, over several years, it indicates effective cost management and revenue growth strategies. This gives you an understanding that your growth strategy is working and fruitful.
  • Deteriorations: A declining quick ratio signals worsening liquidity, which shows that your business might face problems meeting its short-term responsibilities, so this area needs to be reviewed.
  • Stability: When your ratios are stable, it shows that your performance has been consistent and this is reassuring for investors and creditors.

3. Expected/Budgeted Performance

Comparing financial ratios against budgeted or expected figures gives you insight into how well a business is on track to achieve its financial goals and strategic objectives. This comparison highlights:

  • Performance Gaps: When there are significant deviations from budgeted ratios, it may be an indication of operational issues or inaccurate forecasting. For example, if the actual profit margin is below the budgeted margin, it suggests higher-than-expected costs or lower-than-expected sales.
  • Achieving Goals: When you meet and exceed budgeted ratios, it demonstrates effective management and strategic alignment, and this helps boost stakeholder confidence.
  • Areas for Improvement: Analyzing discrepancies between actual and expected ratios can help you identify areas that need corrective action, such as asset utilization, cost control, and revenue enhancement.
Examples of Business Decisions Enhanced by Ratios

Here are some examples of business decisions that are aided by ratios:

  • Pricing Decisions Based on Gross Margin: This is one of the major decisions enhanced by ratio. If the gross margin is low, it simply indicates that the company needs to re-evaluate its pricing strategy or reduce its cost of production to maintain profitability.
  • Cost Reduction/Optimization Based on Profit Before Tax Margin: Analyzing this ratio helps you identify areas where you should reduce operational costs to improve profitability.
  • Financing Decisions: You cannot make effective financial decisions without analyzing ratios. The debt-to-equity ratio guides you in making decisions on whether to finance operations through debt or equity. A high ratio indicates a need to raise equity to avoid over-leverage.
  • Operational Decisions: The asset turnover ratio informs you whether the assets have been utilized efficiently or not. This helps you determine whether to acquire new assets or dispose of underperforming ones.
Final Words

Understanding and leveraging financial ratios can significantly enhance your business’s decision-making process. To fully unlock the potential of these insights, consulting a professional accounting service is highly recommended. Mac Adebowale Professional Service is here to give you the best assistance you need. Contact us at emails@macadebowale.com, and let’s get started.