Ratio Analysis

This article will cover some of the most common financial ratios, which can be found using income statements, cash flow, and balance sheet items, to help analyze your business. Analyzing these ratios can help you analyze many aspects of your business, including the following:

Profitability: These ratios can help you measure how profitable your business is, and focus on how costs like materials, labor, interest, or other expenses are impacting your net income.

Liquidity: These ratios measure how easily your business can meet its short-term debt obligations.

Leverage: Leverage ratios are used to show how a company is able to meet its financial obligations, and it shows how effectively a company uses debt to finance its growth.

Efficiency: These ratios measure how effectively a company uses its assets to generate income.

Big 5 Numbers: Big 5 numbers are also a useful way to analyze the growth of your business, and to determine how effectively you are using your investment capital.

You can utilize these ratios to analyze your business, and you can also compare them to relevant peer groups if applicable.


Profitability Ratios to Consider

One of the most useful things about analyzing an income statement is that you can use information from this financial statement to calculate financial ratios and margin ratios. These figures can help you further analyze your business.


There are various types of margin ratios to consider, including the following:


Gross Margin Ratio

The gross margin is a profitability ratio that shows how much money a company has left over after paying for the cost of producing a product. It can be calculated as follows, and is expressed as a %:

Gross Margin Ratio = ( Revenue- Cost of goods sold)/ Revenue

If a company’s gross margin ratio is 60%, this means that it needs to spend $0.40 on the cost of the product per $1 in revenue before retaining a profit.

Once you have calculated your gross margin ratio, you can compare it to peer companies in your industry to see how your business is performing. After this, you can think of ways to lower your cost of goods sold if necessary, by changing suppliers to using different materials. Furthermore, some businesses may choose to raise their prices to boost their gross margin, if materials costs are rising too fast.

EBITDA Margin

The EBITDA margin is another type of common profitability ratio that measures how much money a company had made before paying interest, taxes, depreciation, and amortization. The EBITDA margin is expressed as a %, and calculated by dividing the company’s EBITDA by the total revenue.


EBITDA Margin= EBITDA/Revenue

When calculating EBITDA, you will subtract the cost of goods sold and SG&A expenses. This ratio is a better way to focus on a company’s total operating expenses and excludes other non-operating costs like depreciation, interest, and taxes. This ratio is also very common in M&A analysis, as it is often seen as a better way to value a business. Companies who want to buy a small business may look at the average EBITDA of the industry, and see how the company prepares.


EBIT Margin

The EBIT margin is similar to the EBITDA margin but is different in the fact that it includes the impact of depreciation and amortization. This ratio calculates how much money a business makes before paying interest and taxes.

It is calculated as followed, and expressed as a percentage:

EBIT margin= EBIT/Revenue

Analyzing a company’s EBIT margin can be a great way to examine its profitability, but it does have some limits. A company could have a favorable EBIT margin, but if its cost of capital is extremely high, then it may not be very profitable. Furthermore, you would also need to examine the company’s tax rate, to see how profitable it would be after paying taxes.

Operating margin

The operating margin, referred to as the return on sales, shows how much money a company makes after paying its operating expenses. The company will need to deduct costs like COGS, rent, deprecation, and wages before arriving at its operating income. The operating margin is calculated as follows:

Operating Margin= Operating income/sales

Net income margin

The net income margin, or net profit margin, shows how profitable a company is, as it is based on the company’s bottom line ( profit). Businesses can calculate the net income margin by dividing the company’s profit by the revenue. Companies that are not profitable will have a negative net income margin.

The sample financials listed below can show you how some of these ratios are related to each other.

Once you have calculated your net income, you can also look at balance sheet items to calculate other return ratios, including the return on equity and return on assets.

ROE: ROE, or return on equity, is calculated as the company’s net income divided by the total equity. You can find a company’s equity by looking at its balance sheet and finding the net income on the income statement. For example, a company with equity of $10 million, and net income of $2 million would have an ROE of 20% ( $2 million/$10 million).


ROA: ROA, the return on assets, is the company’s net income divided by the total assets. If a company’s assets are $20 million, and it records a net income of $5 million, then the company’s ROA would be 25% ( $5 million/$ 20 million). ROA is a measure of how a business effectively uses its assets to create value for its owner, and this ratio is best for asset-heavy businesses.Leverage Ratios to Consider


Another important area of your business to analyze is the amount of leverage you are using, as this can help you make key decisions about managing your business’s debt. There are many ratios available, which compare the company’s debt to either its total assets or equity. Leverage ratios can be a great way to see if you are at risk of defaulting on a loan, although you will also need to look more closely at your cash flow statement after calculating these leverage ratios.


Debt to Assets: The debt to asset ratio is calculated as the company’s total debt divided by its total assets. All of the company’s debts, including short-term and long-term debt, are included in this calculation. In general, it is best for businesses to have a debt-to-asset ratio below 1.0x, and a ratio above 1 indicates that this business may be risky. A debt-to-asset ratio of 0.3 indicates that 30% of the business is financed by creditors and 70% belongs to the owners in the form of equity. There are some limitations to solely relying on this formula, as it does not distinguish between short-term and long-term debt, and does not provide details about the types of assets owned.

Debt to Equity: The debt to equity ratio, which is also called gearing, is equal to the company’s total debt divided by its equity. When small businesses refer to the term leverage, this is often the first ratio that they refer to. This ratio shows how much a company relies on debt financing, rather than equity, to fund its expansion. Some investors may choose to modify this ratio to only include long-term debt, as this can more accurately reflect its risk of defaulting on its loans. In some cases, a high debt/equity ratio can be beneficial, if the additional return generated by the debt financing exceeds the interest expense of this debt.

Debt to Capital: The debt to capital ratio is another way to measure a company’s financial leverage, and it includes both short-term and long-term debt. In order to calculate this ratio, you  can take your company’s total debt, including long-term and short-term debt, and divide it by your total capital. A higher debt-to-capital ratio also indicates that the company is riskier because it is more leveraged.


Debt to Capital Ratio= Debt/ Debt+ Shareholder’s equity

Asset to Equity Ratio: The asset to equity ratio is another way to measure a company’s leverage, and it is equal to the company’s total assets divided by the total equity. A higher ratio indicates that a company is taking on more debt, rather than equity, to fund its expansion. Small businesses can use this ratio, in combination with the debt/equity ratio, to determine if a company is taking on too much.


You can also use items from your income statement to calculate various debt ratios.

Debt/EBITDA: This ratio is useful because it shows how much of the company’s income that it generates is available to pay its debt. Companies can use this ratio to calculate how long it may take them to pay off their debt. Moreover, companies can also use a net debt/EBITDA, which is based on the company’s debt minus its cash and cash equivalents. This ratio is more useful for companies with higher debt amounts, that also have strong cash balances.

Debt Service Coverage Ratio: The debt service coverage ratio is another useful leverage ratio that shows how likely a company will be able to pay back its debt. It is calculated as the company’s net operating income divided by the sum of the interest and principal payments that a company makes. This ratio is useful because it shows the actual payment, rather than the amount of debt a company has. Companies with equal debt amounts could have dramatically different payments based on differences in the loan term and interest rate.

Liquidity Ratios


Liquidity ratios are useful ratios that help companies calculate how easy it would be for them to meet their short-term debt obligations. Three of the most common liquidity ratios that analysts use include the quick ratio, current ratio, and cash ratio. If any of these ratios are below 1x, it means that the company may not be able to cover its short-term liabilities and that the company is risky.


Current Ratio: The current ratio is based on the company’s current assets and current liabilities, and shows how likely a company is to pay all of its debts that are due within one year. Some of the company’s current assets can include cash, cash equivalents, and other highly liquid assets, while current liabilities include accounts payable, short-term debts, taxes due, and the short-term (12 months) portion of the company’s long-term debt.


Current Ratio= Current assets/Current Liabilities

Quick ratio: The quick ratio is calculated based on the company’s most liquid assets, which can easily be converted into cash, to pay its short-term liabilities. This ratio is more useful than the current ratio because it does not include certain current assets like inventory, which may take longer to sell.

Quick Ratio= ( Current assets- inventory)/ Current Liabilities


Cash Ratio: The cash ratio is used to show how quickly a company is able to pay its short-term debt obligations using cash. This ratio only includes the company’s cash and cash equivalents, so it is an accurate way to ensure a company can meet its short-term debt obligations.Cash Ratio= ( Cash + cash equivalents)/ Current Liabilities

Efficiency Ratios

Efficiency ratios are also useful to analyze, as they show you how efficiently your business is using assets to produce income. There are four common types of efficiency ratios, including inventory turnover ratio, accounts receivable turnover ratio, accounts payable turnover ratio, and asset turnover ratio. Companies can choose whatever time period they want to use, such as quarterly or annually, but most companies choose to do this on an annual basis.


Inventory Turnover Ratio: Small businesses can use this ratio to determine how long it takes them to sell all of their inventory. The formula for this ratio is the total COGS over a set period divided by the average inventory. This ratio can help businesses ensure they are selling their inventory fast enough, and also develop inventory management techniques to ensure they do not hold too much inventory.Inventory turnover ratio= COGS/Average Inventory

Asset Turnover ratio: The asset turnover ratio is somewhat similar to the ROA ratio, which takes the company’s net income and divides it by the total assets. However, the asset turnover is calculated based on the company’s net sales instead, and it is also based on the average assets.Asset turnover ratio= Net Sales ( Sales-allowances-discounts)/ Average Assets over a period

Accounts Receivable Ratio: Many businesses who sell products on credit will need to ensure they are managing their accounts receivable properly so that they can avoid cash flow issues. The accounts receivable ratio is a useful tool that allows businesses to calculate how often it is able to collect accounts receivable over a given period.

Accounts Receivable Ratio= Net Credit Sales/Average Accounts Receivable

Accounts Payable Ratio: Similarly, businesses that have a large accounts payable balance need to ensure that their cash flow is strong enough to avoid making late payments. The accounts payable ratio is a useful liquidity ratio that shows how many times a company pays its creditors during a certain period.

Accounts Payable Ratio= Net Credit Purchases/Average Accounts Payable

Big 5 Numbers

Big 5 Numbers are also used to determine if businesses have a sustainable moat and are operating efficiently. These ratios are commonly used for publicly listed stocks, but can also apply to small businesses as well. The Big 5 Numbers include return on investment capital, sales growth, earnings growth, equity or book value growth, and cash flow growth.

Return on investment capital: The ROIC ratio determines how efficiently a business uses its capital. In order to calculate this formula, you need to calculate your net profit after tax and divide it by your invested capital. The value is expressed as a %, and you can compare this to your cost of capital to see how effective your operations are. If your ROIC is lower than your cost of capital, then you are not investing your capital efficiently.


ROIC= net operating profit after tax/ invested capital

Sales Growth: Sales growth or revenue growth is one of the simplest ways to analyze how fast your business is growing. You can calculate your sales growth over a certain period, such as a year or quarter, and you can also examine historical growth over a long period.

Sales Growth= ( Sales in Year X- Sales in the previous year)/Sales in previous year

Earnings growth: Earnings per share growth, or earnings growth, is another way to measure how fast your net income is growing. Publicly traded companies have earnings-per-share calculations, to account for the impact of share dilution.

Earnings Growth= ( Earnings in Year X- Earnings in the previous year)/ Earnings in previous year

Equity Growth Rate: Small businesses can also examine their balance sheet every year or quarter to determine how fast their equity is growing.

Equity Growth Rate= ( Equity in Year X- Equity in the previous year)/ Equity in the previous year

 
Cash Flow: The cash flow growth rate measures how fast a company is growing its cash flow every year or quarter. The cash flow rate can be based on the company’s free cash flow or operating cash flow.

Cash Flow Growth Rate= ( Cash Flow in Year X- Cash flow in the previous year)/ Cash flow in previous year

Categorised in: Planning

This post was written by Sean Allaband