Did you know that more than 90 percent of successful investors apply financial ratios to gauge the performance of a company in making investment decisions? This is a testimony to the importance of knowing the figures that a business is dealing with. Learning about the Top 10 financial ratios for smart investing is not only limited to those in the financial field but should be learned by the common man in order to make sound and confident investment decisions. These ratios will help you separate the wheat and the chaff and concentrate on what is important, to find out the profitability of a company, its liquidity, efficiency, and financial health. Here in this blog, we will discuss the most significant financial ratios in simple language so that you can analyze investments like a professional.
What is Financial Ratio?
A financial ratio is a mathematical instrument assisting in the assessment of the performance of a company by comparing the significant financial data provided in the balance sheet, income statement, or cash flow statement of a company. These important financial ratios can give information about different matters of a business including profitability, liquidity, efficiency, and solvency. No matter whether you are about to start up a company or have a firm running, applying appropriate financial ratios for small business can assist you in making wiser financial choices and tracking the growth of the company.
In writing a financial ratios business plan, it is important to know the ideal financial ratios in order to impress the investors and lenders. Whether it is key profitability ratios such as the net profit margin and the return on assets or business ratios such as the current and debt-to-equity ratio, every ratio is specific in assessing the financial health of a company. These ratios serve as the measuring rod, and they enable you to determine whether your business is in the right direction or if it requires some strategic changes.
Let’s look into top 10 financial ratios for business;
- Quick Ratio
- Current Ratio
- Inventory Turnover Ratio
- Return on Investment (ROI)
- Return on Capital Employed (ROCE)
- Return on Equity (ROE)
- Earnings per Share (EPS)
- Debt-Equity Ratio (DER)
- Debtor Turnover Ratio
- Cash Ratio
Quick Ratio
A quick ratio is one of the important financial ratios that shows that a firm can meet its financial obligations and pay off its liabilities even in the case of an unanticipated situation. This ratio indicates the extent to which a company has quick assets to pay off its current liabilities. The higher the ratio, the higher the solvency level of the company and the less the risk of being bankrupt.
Quick Ratio = (Current Assets, Loans & Advances – Current Inventory- Prepaid Expenses) / Current Liabilities & Provisions – Bank Overdrafts
For financial ratios for small business, the quick ratio is crucial for maintaining operational stability.
Current ratio
The current ratio is an ideal financial ratio that shows a company’s present financial strength. It is similar to the Quick Ratio, and this is also used to determine the short-term solvency of a company. A good current ratio indicates a strong short-term solvency position of the company. Sometimes, people also refer to this as the working capital ratio.
Current Ratio = (Total Current Assets, Loans & Advances) / Total Current Liabilities & Liabilities
Including this in a financial ratios business plan shows lenders that your company has sound short-term financial health.
Inventory turnover ratio
The inventory turnover ratio shows how frequently a company converts inventory into sales. Also, this ratio reveals the inventory holding period. The shorter the holding period, the faster the conversion of inventory into sales indicating better efficiency.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
ROI (Return on Investment)
This is particularly helpful among financial ratios for small business dealing in physical products.
ROI basically compares the amount you invest in your business to how much money you make from that investment. This ratio measures the profitability of your business. The higher the ROI Ratio, the higher the profit your business will make. Investors also check this ratio as a primary indicator before investing money in any business.
ROI = (Earnings – Initial Cost of Investment) / Initial Cost of Investment
ROI is a must-have metric in any financial ratios business plan to project potential investor returns.
Return on Capital Employed (ROCE)
This ratio indicates the return by the company on its total investment. It is the ultimate measure of the company’s overall performance and productivity of capital employed, this ratio when compared with the industry average gives an indication of the financial performance of the company. ROCE is a very useful ratio in analysing capital-intensive companies in telecom/oil and gas / heavy industries etc.
ROCE = Profit before interest and taxes / Total Capital employed
Among ideal financial ratios, ROCE is vital for determining how well the company converts capital into profits.
Return on Equity (ROE)
This ratio indicates the income earned by equity shareholders. A high ratio means a high dividend, better prospects and a high valuation in the capital market.
Equity shareholder Funds = Equity Share Capital + Reserves and Surplus +/- Deferred Tax Assets or Liabilities
ROE = (Profit after tax- Preference dividend / Total capital employed) * 100
Including ROE in your business ratios analysis helps attract investors looking for healthy equity returns.
Earnings per Share (EPS)
EPS is one of the important financial ratios for a business. This ratio shows the earnings made on each share of a company. It is one of the important measures of profitability for analysts or investors. This ratio is the main consideration for the valuation of companies in case of mergers, etc. A higher ratio shows that the company is in a positive light. A higher ratio indicates higher returns.
Earnings per share (EPS) measures the net income earned on each share of a company’s stock.
EPS = Profit after tax- Preference dividend / Number of equity shares
EPS is a core metric in any financial ratios business plan meant to appeal to shareholders.
Debt-Equity Ratio (DER)
This ratio indicates whether the company is relying on its own funds or borrowed funds. The debt-equity ratio shows a firm’s total long-term debt as a percentage of its owner’s total equity.
Higher the debt, more fixed liabilities by way of interest and more financial risk for the company. This ratio also indicates whether the company has an optimal capital structure to improve the returns available to equity shareholders.
Debt-equity ratio = Long-term debt / Equity
For financial ratios for small business, DER is a critical measure for maintaining sustainable growth.
Debtor Turnover Ratio
The efficiency with which debtors are converted into cash is shown by this ratio. The higher the ratio, the greater the speed with which debtors are converted into cash. One can also express this ratio in terms of the number of days.
Debtor Turnover Ratio = Net Sales/Average Debtors
It’s particularly useful for small businesses and should be part of your financial ratios business plan.
Cash ratio
The working capital ratio considers only cash and cash equivalents when calculating this ratio. Cash equivalent refers to the total value of cash in hand that includes items that are similar to cash or investments that mature within 90 days. Treasury bills, Treasury notes, and Commercial paper are some examples of cash equivalents. The following is the formula to find the cash ratio:
Cash ratio = Cash and cash equivalents/Current liabilities
Among financial ratios for small business, this is useful for assessing the absolute short-term strength of a company.
How can Finline Help you to Create a Project Report for Bank Loan?
It is a good idea to know the most popular top 10 financial ratios in case one is operating a business. These ratios assist you to follow profits, control cash flow, and understand whether your business is healthy financially. Be it the ROI, current ratio, or the EPS, all these provide you with important information to make a superior decision.
In case you have to prepare a project report on these ratios, Finline can assist you. Finline is an online platform that assists you to create financial reports for bank loans and investments – like Canva, but for financials. Within 10 minutes you can create a professional business plan, in your own language! The best part? All the major banks in India accept our reports.
Click now to create your report and take the next step for your business.