top of page
  • Writer's pictureBrian R. Schobel, CPA

Using Financial Ratios to Assess Business Health


Understanding the financial health of a business is crucial for decision-making and strategic planning. Financial ratios provide a quick, comprehensive glimpse into a company's performance, liquidity, solvency, and profitability. Here’s how to use these ratios effectively to gauge the health of a business.


Profitability Ratios

  • Gross Profit Margin: (Gross Profit / Revenue) x 100. Measures the percentage of revenue exceeding the cost of goods sold.

  • Net Profit Margin: (Net Income / Revenue) x 100. Shows the percentage of sales remaining after all expenses.

  • Return on Equity (ROE): (Net Income / Shareholder's Equity) x 100. Indicates how effectively management uses equity to generate profit.

Liquidity Ratios

  • Current Ratio: Current Assets / Current Liabilities. Ratios above 1 suggest adequate assets to cover short-term obligations.

  • Quick Ratio: (Current Assets - Inventory) / Current Liabilities. Measures ability to meet short-term obligations without selling inventory.

Solvency Ratios

  • Debt to Equity Ratio: Total Debt / Total Equity. Shows how a company finances its assets via debt versus equity.

  • Interest Coverage Ratio: EBIT / Interest Expenses. Assesses ease of covering interest payments with earnings.

Efficiency Ratios

  • Inventory Turnover: Cost of Goods Sold / Average Inventory. Indicates the speed of inventory sale and replacement.

  • Asset Turnover Ratio: Net Sales / Total Assets. Reflects how effectively assets are used to generate sales.

Market Value Ratios

  • Price to Earnings Ratio (P/E): Market Price Per Share / Earnings Per Share. Compares share price to earnings, indicating growth expectations.

  • Dividend Yield: Annual Dividends Per Share / Price Per Share. Shows the percentage of earnings returned to shareholders as dividends.

Conclusion

Monitoring these ratios provides insights into operational effectiveness, financial stability, and market perception. They help stakeholders make informed decisions, predict challenges, and guide strategic planning for long-term success. Regular analysis of these ratios is crucial for maintaining a robust overview of business health.

Check us out:



Comments


bottom of page