Introduction

Key performance indicators (KPIs) are a joy to every analyst because they give them a method of understanding how an underlying business is doing using a few calculations. Getting the numbers is simple, but interpreting them in a meaningful way can be an art.

In this article, we will outline the four financial ratio categories, a few of the main ratios within those categories, and how looking at the ratios overall can give you a glimpse into the overall health of your business.

Important Considerations

Before we discuss these ratios, it is important to keep a few things in mind. These ratios are numbers, not fortune tellers. Simply taking them at face value does not always give a perfect picture of what is causing the changes. Asking yourself what circumstances changed the numbers will help you better understand your business dealings.

Having accurate historical data to compare your business timeline is essential. The cherry on top is if you can get benchmarks of other company ratios in your industry. Being able to have comparisons to either your past self or to your peers will allow you to have the anchor that helps guide your thought process in determining how your business is doing and why you are where you are.

Profitability Ratios

One of the most prevalent thoughts in a business owner’s mind is “How much money am I making?” Profitability Ratios allow you to be able to see just how effectively and efficiently your business is at turning expenses into income.

Net Profit Margin Ratio

The most infamous of all the ratios is a simple one to calculate. Net profit margin looks at your revenue after all the costs have been taken out and divides it by the overall revenue. Every company should be keeping track of their net profit margin and how it moves over time.

Net profit Margin % = (Revenue – Cost of Goods Sold – Operating Cost – Tax)/Revenue x 100

The net profit margin lets you know how effectively you are spending money versus how much is coming out in profit. The higher the profit margin, the more money that you could expect to receive for every dollar spent.

Example: A business has revenue of $100,000, the COGS are $20,000, operating costs are $17,000, and your taxes are $5,000. Your net profit margin would be 58%.

($100,000 – $20,000 – $17,000 – $5,000)/($100,000 x 100 = 58%)

Return on Assets (ROA)

This formula is great for businesses that are asset-heavy and use them to produce a good/service. Assets could range from machinery, transportation vehicles, or inventory. The formula looks at net income and the average of your total assets. The main reason you look at an average is because business dealings can cause swings in the quantity of total assets you have, especially in the case of companies with large inventory. Therefore, you can get a more accurate representation of what your assets look like if you get an average. Typically, you would get the average assets from the current month plus the previous month divided by 2.

Return on Assets (ROA) = (Net Income)/(Average Total Assets)

ROA lets you know your profit generation relative to the overall value of your assets. This ratio is best used when compared to historical values of your own company as well as benchmark businesses in the same industry. If you find yourself to be an outlier or have outlier months, you might want to look at your underlying assets and what might have caused a fluctuation. The causes could range from over/under buying inventory to allowing a discount for a large bulk order.

Gross Margin Ratio

This ratio looks similar to the net profit margin but comes with a key difference. Gross margin ratio looks at your gross income compared to your total revenue as opposed to the net profit margin looking at net income compared to total revenue. When you calculate gross revenue, you take your revenue minus cost of goods sold (COGS) whereas net income subtracts out all expenses from revenue.

Gross Margin = (Revenue – Cost of Goods Sold)/Revenue x 100

This difference matters because gross margin allows you to understand how much revenue you are getting from the direct costs that go into your product/service.

Example: Let’s look at the same example we used for the net profit margin. A business has revenue of $100,000, the COGS are $20,000, operating costs are $17,000, and your taxes are $5,000. This time, instead of including operating costs and taxes, you will only subtract out the COGS. Therefore, the ratio would be 80%.

($100,000 – $20,000)/$100,000 x 100 = 80%

One of the greatest reasons to come up with several KPIs for your business is so you can compare them. An excellent case could be made here to compare your net profit margin of 58% and your gross profit margin of 80%. You might ask yourself where the 22% difference comes from. In the operating costs you may see that you are paying too much for rent, or perhaps you had higher advertising costs for the period you are looking at.

Solvency Ratios

Solvency ratios are used for assessing your debt levels which helps you understand the likelihood that you will be able to stay solvent and how easy it is for you to pay off your long-term debts. These ratios are often what lenders look at as they evaluate whether to give you more money.

Debt-Equity Ratio (D/E Ratio)

Calculating the D/E ratio requires the use of the balance sheet to find your total liabilities and total shareholder equity. This ratio shows you where your continued growth is coming from. A higher D/E ratio means that you are funding more of your growth using loans and debt which typically requires interest payments and origination fees whereas a lower ratio will show more of your outside funding is coming from your investments, issuance of stocks, or the business is generating a net income.

D/E Ratio = (Total Liabilities)/(Total Shareholders’ Equity)

When evaluating this formula, it’s important to consider what is held in the liabilities account, whether it’s mostly consisting of long-term or short-term debt and what kinds of rates they currently hold. When looking at total shareholders’ equity, you’ll want to see if the fluctuations are from owners putting money in/taking money out, from a profitable/unprofitable year, or if they issued more shares/bought shares back.

Debt-Assets Ratios (D/A Ratio)

The D/A ratio compares total debt to total assets. This allows you to see the measure of leverage that the business holds. It also tells you how much debt the business has utilized compared to the amount of equity that is in the business. For example, if the ratio is 0.35, 35%, then that means the assets are funded 35% through debt and the rest is from shareholders’ equity.

D/A Ratio = (Short-Term Debt + Long-Term Debt)/(Total Assets)

If you find yourself having a ratio over 1.0, that would mean that your company is insolvent because you have more debts than your business can cover. Creditors look at this ratio to see how much debt the company has and its repayment abilities in the event that the business needs to be liquidated. For new investors into the business, they would want to look at this ratio to make sure that the business can still pay out returns on their investment.

Interest Coverage Ratios

Interest coverage ratios are a measure of how many times a company can pay for their current interest expense on their debt using their revenue after COGS, operating expenses, and depreciation & amortization are taken out.

Interest Coverage Ratio = (Earnings before Interest and Taxes)/(Interest Expense)

Interest coverage ratios are great for understanding how much extra income you would need to be able to pay for the interest expenses if you were to take on more debt. A higher ratio means you have more ability to pay off higher debts.

Liquidity Ratios

Liquidity ratios are a way to determine how you can handle the short-term debts and financial needs. These are also ratios that bankers look at to assess repayment ability.

Current Ratio

The current ratio is looking at a company’s short-term capabilities by seeing how weighted the current liabilities, which include short-term debt obligations and payables, are to their current assets, which include cash, cash equivalents, inventory, and receivables. Having a higher current ratio means you are better suited to meet your short-term debt obligations because you have the assets to cover the expenses.

Current Ratio = (Current Assets)/(Current Liabilities)

Now is a good time to remember that looking at a single number doesn’t paint the entire picture of a company’s overall health. At times, you might see a ratio of less than 1.0 which would indicate that a company can’t cover their immediate needs. This isn’t totally abnormal, especially for smaller companies with less buying power that may have a mismatch between their accounts receivable and their accounts payable. Perhaps they have a seasonal business where they don’t have the current revenue coming in because it’s their offseason. Try to always look at these numbers in a historical context with benchmarks when available to get a better understanding of how the business is trending.

Quick Ratio

This is another ratio similar to the current ratio where a company is evaluating their ability to pay off their short-term debts.

Quick Ratio = (Cash + Cash Equivalents + Accounts Receivable)/(Current Liabilities)

The main difference between this ratio and the current ratio is leaving out the inventory from the assets. The logic behind this is that inventory may not be a liquid asset and if you were to try to sell the inventory, the business may have to sell it at a large discount to quickly liquidate.

Working Capital Turnover Ratio

Working capital turnover ratio can be seen as both a liquidity and efficiency ratio. This is because it measures how well the company is turning short-term assets and liabilities into sales. A higher ratio could show that the company is operating at peak efficiency and is utilizing their given resources well. On the contrary, a low ratio could show that a company is not collecting their receivables in a timely manner, or they have too much short-term debt or payables that are becoming a burden on the overall health of the business.

Working Capital Turnover = (Net Annual Sales)/(Average Working Capital)

Where

Average Working Capital = ((CA yr 1 – CL yr 1) + (CA yr 2 = CL yr 2))/2

CA = Current Assets

CL = Current Liabilities

yr = Year

Efficiency Ratios

Efficiency ratios show how efficiently companies utilize assets and liabilities to create sales.

Inventory Turnover Ratio

The inventory turnover ratio shows how many times a company turns over their inventory in a given time period. A higher ratio indicates strong sales or efficient purchasing whereas a lower ratio indicates slow demand, overspending on COGS, or bottlenecks in your sales cycle.

Inventory Turnover = COGS/(Average Value of Inventory) x 365

Receivables Turnover Ratio

Receivables turnover ratio is an important metric in learning how well a company can collect on their outstanding invoices. A longer time taken to collect makes meeting their short-term debt obligations more burdensome and could cause long-term problems as they are constrained on their ability to grow.

Receivables Turnover = (Net Credit Sales)/(Average Accounts Receivable)

In this formula, net credit sales are the sales that were sums collected that were originally done on credit.

Example: A business has net credit sales of $100,000 at the end of the year. At the beginning of the year, they started off at an accounts receivable balance of $10,000 and ended the year at an account receivable balance of $15,000. Therefore, their accounts receivable would be 8.0. From that we could then take the next step to see how many days outstanding the typical accounts receivable is. We would do that by taking 365 days per year / 8.0 to get an average duration of approximately 46-day turnover for their receivables.

$1,000,000/(($10,000 + $15,000)/2) = 8.0

Then:

(365 days/yr)/(8.0) = 46 days

Other Ratios

There is a plethora of other ratios out there. Each business could (and should) take important measurable aspects of their business and compare it to another measurable aspect. Typically, businesses will compare one variable to revenue as that’s the easiest to parcel out. Below are a few examples of possible ratios that your business can look at or build from.

Revenue per Square Foot

This is a pretty straight and narrow calculation where you take revenue and divide it by the sq.ft of your store. Revenue per sq.ft is best for retail stores that need to make sure they are maximizing their store space. They can also use it to have store comparability if they have multiple locations of the same store. The owner could use it for A/B testing where they want to test out different formats to see how their customers react to new layouts.

Revenue per sq. ft = (Store Revenue)/(Square Feet of Retail Space)

Complaints per 1,000 Customers

This ratio is a great reminder to not focus solely on financial statements. This ratio concerns how well you are satisfying your overall client base, which can be measured using how many complaints you receive per 1,000 customers. The number of customers doesn’t have to be 1,000; it could be any measure that would suit your business capacity. The formula itself is easy to calculate by taking complaints divided by 1,000, or whichever number fits your criteria.

Complaints per 1,000 Customers = (Complaints Filed)/(1,000)

Revenue per Staff Hour

Another important aspect to look at is how well you are utilizing your employees. This is especially true in service industries when trying to track how efficiently they are working and how many customers they interact with. This could be done on an individual worker basis if you track sales by staffer to compare your employees to each other, see who is operating most efficiently, and see where their efficiency comes from that could be shared with the rest of the staff. Another possible outcome from comparing workers to each other is uncovering if someone is cutting corners to push more customers through the door.

Similarly, understanding your staff levels as a whole compared to how much revenue is coming through the door could help you understand seasonal staffing needs. Perhaps in the winter there is less demand, so you need less staff working at one time. Maybe during holidays or days when you are giving great discounts, you see a lot more traffic coming through your store, so you need additional staff. This could also be seen through the lens of a cleaning company that goes to individual households and commercial buildings, and you noticed it’s taking a long time for your staff to reach the locations so you are needing a better logistics system to make the routes more efficient.             

Revenue per Staff Hour = (Gross Revenue)/(Number of Hours Worked)

Conclusion

Understanding the financial health of your business resonates through all the parts of your business dealings. As you look at the business ratios you can correct any problems that may be occurring before they become a larger issue later on. This also helps business owners get an understanding of what their lenders are looking for and how to present their books in the best light possible.

If you are ever in need of help understanding what your key business ratios mean to your business, reach out to Volpe Consulting & Accounting!