SME Business Guide

Understanding Business Finance - Ratio Analysis

Ratio analysis is a powerful tool for assessing the financial health of a business. It involves the calculation and interpretation of various financial ratios derived from the company's financial statements. Here's a guide to some key ratios and what they can reveal about your business health:

Liquidity Ratios:

  • Current Ratio:

    • Formula: Current Assets / Current Liabilities

    • Interpretation: A ratio above 1 indicates good short-term liquidity. However, a very high ratio may suggest inefficiency in utilising resources.

  • Quick Ratio (Acid-Test Ratio):

  • Formula: (Current Assets - Inventory) / Current Liabilities

  • Interpretation: This ratio provides a more stringent measure of liquidity by excluding inventory. A ratio of 1 or higher is generally considered healthy.

Profitability Ratios:

  • Gross Profit Margin:

  • Formula: (Revenue - Cost of Goods Sold) / Revenue

    • Interpretation: Measures the percentage of revenue retained after direct production costs. A higher margin is generally desirable.

  • Net Profit Margin:

  • Formula: Net Profit / Revenue

    • Interpretation: Indicates the percentage of profit generated from total revenue. A higher margin suggests better profitability.

  • Return on Equity (ROE):

  • Formula: Net Income / Shareholders' Equity

    • Interpretation: Reflects the company's ability to generate profits from shareholders' investments. A higher ROE is usually favourable.

Solvency Ratios:

  • Debt-to-Equity Ratio:

  • Formula: Total Debt / Shareholders' Equity

    • Interpretation: Measures the proportion of debt used to finance the company. A lower ratio indicates less reliance on debt.

  • Interest Coverage Ratio:

  • Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense

  • Interpretation: Indicates the company's ability to cover interest payments with its operating profits. Higher ratios are preferable.

Efficiency Ratios:

  • Inventory Turnover:

  • Formula: Cost of Goods Sold / Average Inventory

    • Interpretation: Measures how quickly inventory is sold. A higher turnover ratio is generally better.

  • Accounts Receivable Turnover:

  • Formula: Revenue / Average Accounts Receivable

  • Interpretation: Indicates how quickly the company collects payments from customers. A higher turnover is preferred.

Market Ratios:

  • Price-to-Earnings Ratio (P/E Ratio):

  • Formula: Market Price per Share / Earnings per Share (EPS)

    • Interpretation: Compares the market value of a share to its earnings. A higher P/E ratio may suggest growth expectations.

  • Dividend Yield:

  • Formula: Dividend per Share / Market Price per Share

  • Interpretation: Indicates the dividend income as a percentage of the stock's market value.

How to Use Ratio Analysis:

  • Benchmarking: Compare your ratios with industry averages to identify areas of strength or weakness.

  • Trend Analysis: Track ratios over time to identify patterns or changes in performance.

  • Interpretation: Consider the interplay of different ratios. For example, high profitability ratios may compensate for higher debt levels.

 

It's important to note that ratio analysis should be used in conjunction with other financial analysis methods, and ratios should be interpreted within the context of the specific industry and company dynamics. Regular monitoring of ratios helps in identifying trends, making informed decisions, and maintaining the financial health of the business.

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