Ratio analysis is a valuable tool for companies to examine trends and relationships in business metric data. It can also help a company understand its performance compared to competitors.
Performing ratio analysis on a regular cadence helps companies identify what is working and what risks still exist looking to the future. Performing financial statement ratio analysis requires clean, comprehensive data and powerful analytics for optimal efficiency.
Profitability Ratio
Ratio analysis is a cornerstone of financial statement analysis that compares line-item data from a company’s balance sheet and income statement to reveal insights about profitability, liquidity, and operational efficiency. These ratios can mark how a business performs over time, help identify areas that may require improvement, and give the company an advantage when it competes with similar companies in its industry.
The most common profitability ratio is the net profit margin, which reveals how much after-tax profit is generated for every dollar of revenue. It is important to note that this ratio is only indicative of the company’s profitability, and doesn’t guarantee future success.
Whether you’re an investor or a small business owner, it’s a good idea to keep track of your company’s ratios on a regular basis. One way to do this is by tracking your business credit score with Nav, which provides you with free and unlimited business credit reports and scores.
Liquidity Ratio
Liquidity ratios are a common and reliable way to see how much cash your company has on hand to pay its short-term liabilities. Investors and creditors rely on them to make sure your company can afford to keep paying its bills before it runs out of money.
These ratios compare current assets to current liabilities, which usually mean debt that will come due within a year. Different ratios have different definitions of current assets, but most include cash and cash equivalents, accounts receivable and marketable securities. Other current assets, such as inventory and prepaid expenses, may be harder to convert to cash.
The most commonly used liquidity ratio is the current ratio, which measures a company’s ability to pay its short-term liabilities with its current assets. A higher current ratio means that a company is more likely to be able to cover its debts without turning to outside lenders. A lower current ratio, on the other hand, could mean that a company will have trouble meeting its short-term obligations.
Cash Flow Ratio
Cash flow ratio is a financial metric that measures how well a business converts its sales into cash. It is a key part of the statement of cash flows, which also includes operating profit and changes in assets. Cash flow ratios can help business owners and investors understand how a firm generates cash. It can also detect company management practices such as income smoothing, which is a practice of reporting higher earnings to secure bonuses.
A low operating cash flow ratio may indicate that a business is unable to cover its current liabilities. However, it should not be used in isolation and it is important to compare it with other metrics. For example, a low operating cash flow ratio should be considered alongside the cash flow coverage ratio, which is calculated as operating cash flow minus long-term debt plus fixed assets purchased. This metric is more accurate than net profit and less susceptible to manipulation.
Return on Investment
The return on investment is one of the most familiar measures used in business. It is simple to calculate and helps a business person compare apples-to-apples among various investment options. It is one of a family of cash flow metrics that includes the payback, NPV and IRR. All of these measures compare likely returns to expected costs, but each offers a different perspective on the resulting cash flow stream.
A result of 10%, for example, tells you that returns exceed costs by 10%. It doesn’t imply that returns will continue to rise or decrease, nor does it indicate how quickly the gains will be realized.
A high ROI is not always a good thing, however. A very high ROI may be indicative of a leveraged strategy that will ratchet up profits but also expose the company to increased risk. A higher ROI can also be misleading if it depends on estimates of future values, which do not take into account any assessment of the probability that those estimated values will actually occur.