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5 key Financial Ratios and How to use them

by Datarails

Updated on March 30, 2023

What are financial ratios?

Financial ratios are basic calculations using quantitative data from a company’s financial
statements. They are used to get insights and important information on the company’s
performance, profitability, and financial health.

Common financial ratios come from a company’s balance sheet, income statement, and
cash flow statement.

Businesses use financial ratios to determine liquidity, debt concentration, growth,

profitability, and market value.

Why are financial ratios so important?

Financial ratios are sometimes referred to as accounting ratios or finance ratios. These
ratios are important for assessing how a company generates revenue and profits using
business expenses and assets in a given period. Internal and external stakeholders use
financial ratios for competitor analysis, market valuation, benchmarking, and
performance management.

Financial Ratios inside a business

Financial planning and analysis professionals calculate financial ratios for the following
reasons for internal reasons.

● To measure return on capital investments

● To calculate profit margins

● To assess a company’s efficiency and how costs are allocated

● To determine how much debt is used to finance operations

● To identify trends in profitability

● To manage working capital and short-term funding requirements

● To identify operating bottlenecks and assess inventory management systems

● To measure a company’s ability to settle debt and liabilities

How analysts and external stakeholders use Financial
Ratios
External stakeholders use financial ratios to:

● Carry out competitor analysis

● Determine whether to finance a company in the form of debt

● Assess how profitable a company is

● Determine whether to provide equity financing or buy shares in the company

● Calculate tax liabilities

● Measure a company’s market value

● Calculate return on shareholders’ equity

● Perform market analysis

Financial Ratios Excel Template

Below is an Excel template with all of the formulas needed for calculating each of the 5
financial ratios. Plug in your company’s numbers and get a quick and accurate picture of
where you stand on liquidity, debt concentration, growth, profitability, and market value.

Download Excel Template

Example of the 5 financial ratios template with the inputs tab and Liquidity ratio as an output. Download the template to use all 5 financial ratios

5 Essential Financial Ratios for Every Business 

The common financial ratios every business should track are 1) liquidity ratios 2)
leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.

1)   Liquidity ratios

Companies use liquidity ratios to measure working capital performance – the money
available to meet your current, short-term obligations .

Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a
company’s capacity to meet its short-term obligations and are a vital indicator of its
financial health. Liquidity is different from solvency, which measures a company’s ability
to pay all its debts. In the sporting world, Italian football club Lazio faces a now-
infamous liquidity ratio preventing it from signing new players. Italian clubs are required
to communicate their liquidity indicator to the football authorities twice a year. This
indicator cannot be any lower than a certain threshold set by the football authorities.

There are different forms of liquidity ratio.

 Current ratio: Current Assets / Current Liabilities

The current ratio measures how a business’s current assets, such as cash, cash
equivalents, accounts receivable, and inventories, are used to settle current liabilities
such as accounts payable.

Quick ratio (Acid-test ratio): (Current Assets – Inventories – Prepaid Expenses) /

Current Liabilities

Also known as the acid-test ratio, the quick ratio measures how a business’s more liquid
assets, such as cash, cash equivalents, and accounts receivable can cover current
liabilities. This ratio excludes inventories from current assets. A quick ratio of 1 is
considered the industry average. A quick ratio below 1 shows that a company may not
be in a position to meet its current obligations because it has insufficient assets to be
liquidated. (Acid test refers to a quick and simple test gold miners used to determine
whether samples of metal were true gold or not. Acid would be added to a sample; if it
dissolved, it wasn’t gold. If it stood up to the acid, it likely was). From a great real
example on the Street.com see how Apple’s Quick Ratio stacks up:

Quick Ratio Example: Apple (NASDAQ: AAPL)

The following figures are as of March 27th, 2021, and come from Apple’s balance sheet.
Numbers are in millions of dollars.

Cash and cash equivalents: $38,466

Accounts receivable: $18,503

Marketable securities: $31,368

Current liabilities: $106,385

QR = Liquid Assets / Current Liabilities

QR = ($38,466 + $18,503 +$31,368) / $106,385

QR = $88,337 / $106,385

QR = 0.83

Based on this calculation, Apple’s quick ratio was 0.83 as of the end of March 2021. This
number could be higher if more assets were included in its calculations.

Cash ratio: Cash and cash equivalents / Current Liabilities

The cash ratio measures a business’s ability to use cash and cash equivalent to pay off
short-term liabilities. This ratio shows how quickly a company can settle current
obligations.

2)    Leverage ratios

Companies often use short and long-term debt to finance business operations. Leverage
ratios measure how much debt a company has. Molson Coors Beverage Co. , the maker
of Coors Light and Miller Lite beer for instance, had been saddled with debt, after an
acquisition in the industry according to the Wall Street Journal. Its CFO Tracey Joubert
signaled to the market the company’s plans “reduce its leverage ratio to below 3 times
by the end of this year.” The types of leverage ratio to consider are:

Debt ratio: Total Debt / Total Assets

The debt ratio measures the proportion of debt a company has to its total assets. A high
debt ratio indicates that a company is highly leveraged.
Debt to equity ratio: Total Debt / Total Equity

The debt-to-equity ratio measures a company’s debt liability compared to shareholders’

equity. This ratio is important for investors because debt obligations often have a higher
priority if a company goes bankrupt.

Interest coverage ratio: EBIT / Interest expenses

Companies generally pay interest on corporate debt. The interest coverage ratio shows
if a company’s revenue after operating expenses can cover interest liabilities.

3)   Efficiency ratios

Efficiency ratios show how effectively a company uses working capital to generate sales.
For instance an analyst reported that Seattle-based bank Washington Federal’s
company’s efficiency ratio was 58.65%, down from 59.02% recorded a year ago. A fall in
efficiency ratio indicates improved profitability. There are several ways to analyze
efficiency ratios:

Asset turnover ratio: Net sales / Average total assets

Companies use assets to generate sales. The asset turnover ratio measures how much
net sales are made from average assets.

Inventory turnover: Cost of goods sold / Average value of inventory

For companies in the manufacturing and production industries with high inventory
levels, inventory turnover is an important ratio that measures how often inventory is
used and replaced for operations.

Days sales in inventory ratio: Value of Inventory / Cost of goods sold x (no. of days in
the period)

Holding inventory for too long may not be efficient. The day sales in inventory ratio
calculates how long a business holds inventories before they are converted to finished
products or sold to customers.

Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average
Accounts Payable

The payables turnover ratio calculates how quickly a business pays its suppliers and
creditors.
Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods Sold) x
Number of Days in Accounting Period (or year)

This ratio shows how many days it takes a company to pay off suppliers and vendors. A
lower days payables outstanding implies that a business is letting go of cash too quickly
and may not be taking advantage of longer credit terms. On the other hand, when the
DPO is too high, it means a company delays paying its suppliers, which can lead to
disputes.

Receivables turnover ratio: Net credit sales / Average accounts receivable

Accounts receivables are credit sales made to customers. It is important that companies
can readily convert account receivables to cash. Slow paying customers reduce a
business’s ability to generate cash from their accounts receivable.

The receivables turnover ratio helps companies measure how quickly they turn
customers’ invoices into cash. A high receivables turnover ratio shows that a company
quickly generates cash from accounts receivables.

4)    Profitability ratios

A business’s profit is calculated as net sales less expenses. Profitability ratios measure

how a company generates profits using available resources over a given period. Higher
ratio results are often more favorable, but these ratios provide much more information
when compared to results of similar companies, the company’s own historical
performance, or the industry average. Some of the most common profitability ratios are:

Gross margin: Gross profit / Net sales

The gross margin ratio measures how much profit a business makes after the cost of
goods and services compared to net sales. Comparing companies can be illustrative –
such as finding that Home Depot has a 33.6% gross profit margin versus Walmart’s
25.1%.

Operating margin: Operating income / Net sales

The operating margin measures how much profit a company generates from net sales
after accounting for the cost of goods sold and operating expenses.
Return on assets (ROA): Net income / Total assets

Companies use the return on assets ratio to determine how much profits they generate
from total assets or resources, including current and noncurrent assets.

Return on equity (ROE): Net income / Total equity

Shareholders’ equity is capital investments. The return on equity measures how much

profit a business generates from shareholders’ equity. For instance a company with a
declining ROE could be seen as having more risk than a company in the same industry
with an increasing ROI.

5)   Market Value ratios

Market value ratios are used to measure how valuable a company is. These ratios are
usually used by external stakeholders such as investors or market analysts but can also
be used by internal management to monitor value per company share.

Earnings per share ratio (EPS): (Net Income – Preferred Dividends) / End-of-Period
Common Shares Outstanding

The earnings per share ratio, also known as EPS, shows how much profit is attributable
to each company share.

Price earnings ratio (P/E): Share price / Earnings per share

The PE ratio is a key investor ratio that measures how valuable a company is relative to
its book value earnings per share.

Book value per share ratio: (Total Equity – Preferred Equity) / Total shares outstanding

A company’s common equity is what common shareholders own after all liabilities and
preference shares have been settled from total assets.

The book value per share measures the value per share for common equity owners
based on the balance sheet value of assets less liabilities and preference shares.

Dividend yield ratio: Dividend per share / Share price

The dividend yield ratio measures the value of a company’s dividend per share
compared to the market share price.
When companies pay out dividends to shareholders, the value of dividends received for
each share owned is known as the dividend per share. Shareholders and analysts
compare the dividend per share to the company’s share price using the dividend yield
ratio.

Best Practices For Using Financial Ratios

Financial ratios help senior management and external stakeholders measure a
company’s performance. These best practices will drive effective decision-making.

● Compute financial ratios with accurate financial numbers

● Compare ratios across periods to identify performance trends

● Use relative competitor and industry benchmarks to measure performance

● Calculate ratios using balance sheet averages where applicable

● Interpret financial ratios correctly to support key business decisions

● Calculate and analyze ratios using the balance sheet, income statement, and cash flow
statement to get a holistic view of the business’s performance

Final Thoughts
Financial ratios are good key performance indicators used to measure a company’s
performance over time compared to competitors and the industry. Calculating accurate
financial ratios and interpreting the ratios help business leaders and investors make the
right decisions.