Ratio analysis is the act of using various components of financial information in order to provide a snapshot of a company’s financial health. Ratio analysis is frequently used by business owners as well as investors who want better insight into the financial performance of the business in a variety of areas.
Overview: What is ratio analysis?
Ratio analysis can be used in numerous ways, but is most often used to view and analyze trends, compare results with similar businesses, and offer investors insight into the financial well-being of a company they may be interested in.
There are hundreds of variations of financial ratios that can be performed, with many of the calculations requiring only accurate financial statements in order to complete.
However, understanding the results of the calculations is more challenging for small business owners with limited knowledge of bookkeeping or accounting processes.
Ratio analysis categories
Though there are hundreds of different accounting ratios that a business can use to analyze business health and performance, there are five basic categories of ratios that businesses most frequently use. We’ve included the five most common ratio categories as well as an example of a ratio in each particular category.
1. Profitability ratio
Of all the ratios, profitability ratios are probably used most frequently. Profitability ratios measure exactly how effectively a company uses its assets and controls expenses. The gross profit ratio is a good example of a profitability ratio, and is an easy formula:
Total sales – Cost of goods sold = Gross profit ratio
The numbers needed to perform the gross profit ratio are found on your income statement. For instance, a gross profit ratio of 55% means that for every dollar of sales, $0.55 in profit is earned.
A low gross profit ratio means that you’re not generating enough revenue from sales. Profitability ratios, such as cost accounting ratios, can be particularly useful for manufacturing companies.
2. Activity ratio
Activity ratios are designed to measure how effective assets such as inventory or accounts receivable are used. The inventory turnover ratio is a good example of an activity ratio. The inventory turnover ratio involves multiple steps:
- Determine the cost of goods sold, which is found on your income statement.
- Find your beginning and ending inventory totals for the period you wish to calculate turnover ratio for. For instance, if you’re looking for average inventory for the month, you would run a balance sheet on the first day of the month, and the last day of the month, and add the inventory totals from each balance sheet.
Beginning inventory ÷ Ending inventory = Average inventory
- Calculate the turnover ratio:
Cost of goods sold ÷ Average inventory = Inventory turnover ratio
An inventory ratio of 2 means that stock was replenished twice in the specified period of time. An inventory turnover ratio between 2 and 4 indicates that inventory is selling at a profitable rate, while a ratio of less than 1 means that you’re likely overstocked.
3. Liquidity ratio
Liquidity ratios are used to measure the amount of cash available to pay debt. A quick ratio, otherwise known as the acid ratio, is a perfect example of a liquidity ratio. The quick ratio is a simple calculation, using current assets and current liabilities found on your balance sheet.
Current assets ÷ Current liabilities = Quick ratio
A quick ratio of 1 is considered normal, meaning that assets and liabilities are equal. A ratio higher than 1 indicates that your business has more assets than liabilities, while a ratio of less than 1 indicates that your current assets are not sufficient to pay your current liabilities.
4. Debt or leverage ratios
Debt or leverage ratios are completed in order to determine if a company is in position to repay their long-term debt. The most common debt or leverage ratio is the debt-to-equity ratio. The formula for calculating debt to equity is simple:
Total liabilities ÷ Total equity = Debt-to-equity ratio
A debt-to-equity ratio of 1 means that investors and creditors own assets equally, while a ratio higher than 1 means that creditors own more assets than investors, which can indicate that the business is a risky investment.
5. Market ratios
Market ratios measure stock cost and current investment value. The dividend payout ratio is a ratio that compares investor payout to net income generated by a company, and shows current and potential investors how much of their net income a company is distributing to shareholders.
There are several formulas for calculating the dividend payout ratio, with the easiest formula as follows:
Total dividends ÷ Net income = Dividend payout ratio
For example, a dividend payout ratio of 0.20 or 20% means that 20% of net income is distributed to shareholders, while 80% of net income is kept by the company in the form of retained earnings.
How to use ratio analysis
Before calculating ratios, it may be helpful to revisit some frequently used accounting terms that can make the analysis process much simpler.
While investment professionals tend to use financial ratio analysis on a regular basis, it can also be beneficial for small business owners as well.
Business owners will find that using financial ratio analysis can help analyze performance trends while also helping spot potential problems. While some ratios are too complex for smaller businesses, there are numerous ratios that smaller businesses can easily calculate.
Using the example balance sheet below, we’ll calculate a few ratios.
|Total Current Assets||$253,000|
|Total Fixed Assets||$220,000|
|Total Current Liabilities||$70,000|
|Long Term Liabilities|
|Total Long Term Liabilities||$165,000|
|Total Owner’s Equity||$238,000|
|TOTAL LIABILITIES & OWNER’S EQUITY||$473,000|
ABC Manufacturing wants to calculate a current ratio. The formula for a current ratio is
Current assets ÷ Current liabilities = Current ratio
Using the balance sheet totals, here is the calculation for a current ratio:
$253,000 ÷ $70,000 = 3.61
This means that ABC Manufacturing has more than three times as many current assets as current liabilities. Anything greater than 1 is considered good, though if the current ratio is too high, it can indicate that current assets are not being used properly.
A current ratio less than 1 can indicate that your business may have trouble meeting current financial obligations.
Now, we’ll calculate a debt-to-asset ratio, which tells you how much debt your business has assumed and whether you’ve taken on too much debt.
The debt to asset ratio formula is
Total liabilities ÷ Total assets = Debt-to-asset ratio
Using the balance sheet totals, we’ll calculate the debt to asset ratio:
$235,000 ÷ $473,000 = 0.49
This means that your debt to asset ratio is 0.49%, or that you have nearly twice as much in assets as liabilities. Anything less than 0.50 is considered good, while greater 1 is considered high-risk.
Ratio analysis is worth the effort
Calculating ratios for financial analysis is an important part of running a successful business. Even small business owners can benefit from calculating financial ratios, such as accounts receivable turnover, a quick ratio, or a debt-to-asset ratio.
If you’re an accounting novice or unsure which ratios may be beneficial for your business, check with an experienced accountant or CPA for suggestions.
The key to using ratio analysis is keeping accurate financial statements. Using numbers found on a financial statement, ratios can pinpoint what your business is doing right, where it’s headed, and where it may be running into problems.
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