Financial ratios

Liquidity ratio

Purpose: Enable the business to predict its ability to pay off short term debts as they fall due using current assets. Important when a business wants to borrow short term loans from creditors.

Calculated using the current ratio: current assets/current liabilties, taken from the balance sheet

Higher the ratio the better as it indicates a stronger financial position and less risk to lenders

Strategy: Business should increase assets by improving accounts recievable and inventory management to enhance liquidity.

Stability ratio

Purpose: Enable the business and outside investors to determine how much the business relies on external funding to meet its operational needs.

Calculated using the debt to equity ratio: total liabilties/total equity, taken from balance sheet

Lower the ratio the better

High ratios indicate an unstable business that could fail in meeting its financial obligations

Low ratios indicate a stable business providing investors with confidence to put money into the business

Strategy: Reduce debt by prioritising paying off short-term debts - especially ones with high interest and increasing equity through increased sales for increased retained earnings

Gross profit ratio

Purpose: Used as an indicator of a business’ financial health, shows how efficiently a business converts its material and resources into sales

Calculated as gross profit/net sales, taken from P/L statement

Higher the ratio the better

High %= more money retained on each dollar of sales, more money left over for other operating expenses and net profit

Low %= business generates a low level of revenue to pay for operating expenses and net profit, indicates a business cannot control production and COGS, or prices are too low

Strategy: Use cheaper suppliers to lower COGS or increase prices to raise profit

Profit ratio

Purpose: Shows the proportion of every $ of sales that is left over after all expenses have been paid. Net profit is then used to pay taxes and dividends to owners

Calculated as profit/net sales, taken from P/L statement

Higher the ratio the better

High %= operating expenses are low and business has a competitive edge that leads to increased sales and profit

Low %= not generating enough sales, operating expenses are high

Strategy: increasing gross profit through marketing campaigns to attract new customers and increase sales, decrease operating expenses by investing in new, efficient tech

Expenses ratio

Purpose: indicates the ability of a business to spend on expenses and earn a profit

Calculated as operating expenses/net sales, taken from P/L statement

Lower the ratio the better

High %= Low net profit, expenses too high

Low %= business keeps expenses low and earns higher profits

Strategy: Reducing operating expenses by investing in cost-effective tech

Return on equity ratio

Purpose": measures the ability of a business to generate profits from its shareholders investments (how much profit each $ of shareholders equity generates). From the investors point of view

Calculated as profit/equity, taken from both the balance sheet and P/L statement

Higher the ratio the better

Investor wants to see a high % as this indicates that a company is using its investors funds effectively to generate high profits and provide a return for investors

Strategy: Increase gross profit by entering new markets to increase market share and customer base, resulting in increased sales.