1. Profitability ratios
This set of ratios provides different perspectives on the profitability of the business. With the exception of the last one (return on capital employed), they are based on a business’s profit and loss account.
The gross profit margin ratio is one of the most common ratios used to indicate a business’s financial wellbeing. It gives a good indicator of the operational performance of a business. A simple decision, like increasing the unit sales price, can have a significant difference in the gross profit margin, as the following example shows.
Example: Boosting Gross Profit Margin
An electrical retailer purchases TVs for €50 each, and sells them for €100. If the retailer sells 10 TVs (assuming there is no opening or closing stock) then this is how the gross profit is worked out:
Net sales: €1,000 (10 x €100)
Less cost of sales: €500 (10 x €50)
Gross profit: €500
The gross profit margin is 50%. If the retailer sells 10 units at an increased unit sales price of €110 and the purchase price to the retailer remains unchanged at €50, then this is the result:
Net sales: €1,100 (10 x €110)
Less cost of sales: €500 (10 x €50)
Gross profit: €600
Now, the gross profit margin has increased to 54.5% (gross profit €600/net sales €1,100 x 100), because of an increase in the unit sales price.
This ratio compares the overheads, which are costs not directly associated with the production of goods or services, and total sales.
Return on sales
Also known as profit margin, this compares a business’s profit before interest and tax (PBIT) against its sales. This is a good indicator that overall costs in a business are being managed.
Net profit ratio
This ratio takes into account after-tax and interest profit, and compares it with sales.
Return on capital employed (ROCE)
This ratio puts some balance sheet numbers into the mix, specifically capital employed (total assets minus current liabilities). Instead of using capital employed, sometimes total capital is used, but the result is the same.
ROCE compares the return on all the capital that has been employed in the business, and provides a good indicator to a lender or investor as to what type of return the business is generating.
Investors often use this ratio to see if a business is providing a better return than would be available if they put their funds into another type of investment, other kinds of businesses, or managed funds or property.
2. Efficiency ratios
This set of ratios focuses on how efficiently a business is managing its assets. It covers fixed assets, current assets, working capital, asset turnover, stock days, debtor days and creditor days.
Asset turnover ratio
By comparing net sales with average total assets, this ratio indicates a business’s ability to generate sales from its assets.
Fixed asset turnover ratio
This measures a business’s ability to generate net sales from fixed assets such as property, plant and equipment (PP&E). It is calculated net of depreciation.
Working capital ratio
The working capital ratio, which compares current assets with current liabilities, indicates whether a business has enough short-term assets to cover short-term debts.
3. Liquidity ratios
The current ratio shows the proportion of current assets to current liabilities. The current ratio is often assessed, along with the quick ratio, to indicate historical trends and averages for businesses in the same market sector.
Quick ratio (or quick acid test ratio)
This shows the proportion of current assets, excluding the stock figure, to current liabilities.
4. Leverage ratios
These ratios help measure a business’s various methods of financing, as well as its ability to meet financial obligations.
This shows the proportion of a business’s debt to its equity or funds invested by its shareholders plus debt. A business with a high gearing ratio has a high proportion of debt to equity, while a low gearing ratio represents a low proportion of debt to equity.
Debt equity ratio
This compares the amount of debt in a business to the amount of equity or owners’ funds. Businesses with high debt equity ratio are often being financed by their creditors rather than their shareholders or internal cashflow. That’s often viewed as dangerous.
Interest cover ratio
This looks at the relationship between PBIT and interest. It is used to establish how easily a business can pay interest on outstanding debt.
5. Activity ratios
This set of ratios aims to establish how easy or difficult it is for a business to convert different accounts within its balance sheets into cash or sales. These ratios help to establish how efficient a business is at converting its assets into sales or cash.
Accounts receivable days ratio
This is the average number of days it takes for customer invoices to be outstanding before cash is collected. This ratio tests the effectiveness of a business’s cashflow management processes.
Accounts payable days ratio
This is the average number of days it takes a business to pay its trade creditors, such as its suppliers. This ratio also tests the effectiveness of a business’s cashflow management processes.
Stock days ratio
This gives an indication of how long it takes a company to turn its stock into sales.
6. Investor ratios
Return on equity ratio
This is the most common ratio used for comparing the profitability of one business to others within a sector. It measures the net profits against the equity within the business.