Unlocking financial health

Understanding Financial Ratios: A Comprehensive Guide

Knowing your company’s financial health is essential. Financial ratios help you understand different aspects of your business. This guide focuses on three key categories: solvency, liquidity, and profitability.

Keep in mind: ratios are most useful when compared to industry standards and your company’s historical data. Looking at them in context gives a fuller, more accurate picture of performance.

1. Solvency: assessing long-term stability

Solvency ratios show whether your company can meet its long-term obligations. Key metrics include:

• Equity Ratio:Proportion of assets financed by shareholders’ equity. A higher ratio indicates financial strength.
  
• Equity to Debt Ratio:Compares equity to debt, highlighting your capital structure.
  
• Retained Earnings Ratio: Measures how much of the company’s assets are funded by retained profits.
  
• Debt Coverage Ratio: Shows the ability to pay debts using operating cash flow.
  
• Debt Ratio: Percentage of assets financed by debt.
  
• Operating Cashflow Ratio:Evaluates your capacity to cover short-term debts with operating cash flow.
  
• Net Financial Debt:Total debt minus cash and equivalents, reflecting overall indebtedness.
  
• Interest Coverage Ratio: Ability to meet interest payments from operating income. A higher ratio indicates lower default risk.
  

2. Liquidity

Liquidity ratios measure your ability to cover short-term debts. Important metrics:

• Current Ratio: Compares current assets to current liabilities. Above 1 indicates good liquidity.
  
• Days Sales Outstanding (DSO): Average time to collect payments from customers. Lower DSO = faster cash collection.
  
• Days Payable Outstanding (DPO): Average time to pay suppliers. Higher DPO preserves cash but may affect creditworthiness.
  
• Days Inventory Outstanding (DIO): Average time to sell inventory. Lower DIO indicates efficient inventory management.
  
• Cash Conversion Cycle (CCC): Time to turn investments in inventory and receivables into cash (CCC = DIO + DSO – DPO).
• Net working capital (NWC): Current assets minus current liabilities; shows available capital for daily operations.
  
• Cash Ratio: Ability to pay short-term liabilities with cash and equivalents.
  
• Quick Ratio:Similar to current ratio but excludes inventory for a focus on liquid assets.
  
• FCF: Cash generated from operations available for investors, debt reduction, or reinvestment.
  

3. Profitability

Profitability ratios assess how well your company generates profit. Key indicators include:

• EBITDA Margin: EBITDA as a percentage of turnover. Higher margin = better cost management and profitability.
  
• Gross Profit Margin: Percentage of sales revenue remaining after deducting COGS. Measures efficiency of core operations.
  
• Return on Equity (RoE): Efficiency in using equity to generate profits. Higher RoE = better returns for shareholders.
  
• Profitability / Total Liabilities: Ability of profits to cover total financial obligations. Higher value = lower financial risk.