What financial ratio is used to measures the ability of the company to meet long term obligations?

Financial ratios are measurements of a business' financial performance. Ratios help an owner or other interested parties develop an understand the overall financial health of the company.

Financial ratios are used by businesses and analysts to determine how a company is financed. Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability to pay off short term debts, and solvency is the ability to pay off long term debts.

Commonly used financial ratios can be divided into the following five categories.

Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The information you need to calculate these ratios can be found on your balance sheet, which shows your assets, liabilities, and shareholder's equity.

Common liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is an indicator of your company's ability to pay its short term liabilities (debts).

The quick ratio (sometimes called the acid-test) is similar to the current ratio. The difference between the two is that in the quick ratio, inventory is subtracted from current assets. Since inventory is sold and restocked continuously, subtracting it from your assets results in a more precise visual than the current ratio.

The cash ratio is different from both the quick and current ratios in that it only takes into account assets that are the easiest to convert into cash. These assets are cash and cash equivalents, such as marketable securities, money orders, or money in a checking account.

The solvency ratio represents the ability of a company to pay it's long term obligations. This ratio compares your company's non-cash expenses and net income after taxes to your total liabilities (short term and long term).

The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. They use the firm's long-term liabilities on the balance sheet such as payable bonds, long-term loans, or pension funds.

Common financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers to the amount of money and retained earnings invested in the company.

The debt ratio indicates how much debt the firm is using to purchase assets. In other words, it shows if the company uses debt or equity financing.

Sometimes called asset efficiency ratios, turnover ratios measure how efficiently a business is using its assets. This ratio uses the information found on both the income statement and the balance sheet.

The turnover ratios used most commonly are accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts receivable turnover indicate how effective your company is at collecting credit debt.

Accounts payable turnover expresses your efficiency at paying your accounts, and inventory turnover is a measurement of the amount of time it takes to consume and restock your inventory.

When used together, turnover ratios describe how well the business is being managed. They can indicate how fast the company's products are selling, how long customers take to pay, or how long capital is tied up in inventory.

These are ratios that measure if a business' activities are profitable. Frequently used ratios are the net profit ratio and the contribution margin ratio. The contribution margin ratio indicates if your products or services are generating a profit after variable expenses.

The net profit ratio expresses profits after taxes to net sales. This ratio illustrates the percentage of profits remaining after taxes and all costs have been accounted for.

There are many market value ratios, but the most commonly used are price per earnings (P/E) and dividend yield.

The P/E ratio is used by investors to determine if a share of a company's stock is over or underpriced. The dividend yield is an important ratio for investors as it illustrates the return on their investment.

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Financial ratios are basic calculations using quantitative data from a company’s financial statements. They are used to get insights and important information on the company’s performance, profitability, and financial health.

Common financial ratios come from a company’s balance sheet, income statement, and cash flow statement.

Businesses use financial ratios to determine liquidity, debt concentration, growth, profitability, and market value.

Why are financial ratios so important?

Financial ratios are sometimes referred to as accounting ratios or finance ratios. These ratios are important for assessing how a company generates revenue and profits using business expenses and assets in a given period. Internal and external stakeholders use financial ratios for competitor analysis, market valuation, benchmarking, and performance management.

Financial Ratios inside a business

Financial planning and analysis professionals calculate financial ratios for the following reasons for internal reasons.

● To measure return on capital investments

● To calculate profit margins

● To assess a company’s efficiency and how costs are allocated

● To determine how much debt is used to finance operations

● To identify trends in profitability

● To manage working capital and short-term funding requirements

● To identify operating bottlenecks and assess inventory management systems

● To measure a company’s ability to settle debt and liabilities

How analysts and external stakeholders use Financial Ratios

External stakeholders use financial ratios to:

● Carry out competitor analysis

● Determine whether to finance a company in the form of debt

● Assess how profitable a company is

● Determine whether to provide equity financing or buy shares in the company

● Calculate tax liabilities

● Measure a company’s market value

● Calculate return on shareholders’ equity

● Perform market analysis

5 Essential Financial Ratios for Every Business 

The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.

1)   Liquidity ratios

Companies use liquidity ratios to measure working capital performance – the money available to meet your current, short-term obligations .

Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a company’s capacity to meet its short-term obligations and are a vital indicator of its financial health. Liquidity is different from solvency, which measures a company’s ability to pay all its debts. In the sporting world, Italian football club Lazio faces a now-infamous liquidity ratio preventing it from signing new players. Italian clubs are required to communicate their liquidity indicator to the football authorities twice a year. This indicator cannot be any lower than a certain threshold set by the football authorities.

There are different forms of liquidity ratio.

 Current ratio: Current Assets / Current Liabilities

The current ratio measures how a business’s current assets, such as cash, cash equivalents, accounts receivable, and inventories, are used to settle current liabilities such as accounts payable.

Quick ratio (Acid-test ratio): Current Assets – Inventories / Current Liabilities

Also known as the acid-test ratio, the quick ratio measures how a business’s more liquid assets, such as cash, cash equivalents, and accounts receivable can cover current liabilities. This ratio excludes inventories from current assets. A quick ratio of 1 is considered the industry average. A quick ratio below 1 shows that a company may not be in a position to meet its current obligations because it has insufficient assets to be liquidated. (Acid test refers to a quick and simple test gold miners used to determine whether samples of metal were true gold or not. Acid would be added to a sample; if it dissolved, it wasn’t gold. If it stood up to the acid, it likely was). From a great real example on the Street.com see how Apple’s Quick Ratio stacks up:

Quick Ratio Example: Apple (NASDAQ: AAPL)

The following figures are as of March 27th, 2021, and come from Apple’s balance sheet. Numbers are in millions of dollars.

Cash and cash equivalents: $38,466

Accounts receivable: $18,503

Marketable securities: $31,368

Current liabilities: $106,385

QR = Liquid Assets / Current Liabilities

QR = ($38,466 + $18,503 +$31,368) / $106,385

QR = $88,337 / $106,385

QR = 0.83

Based on this calculation, Apple’s quick ratio was 0.83 as of the end of March 2021. This number could be higher if more assets were included in its calculations.

Cash ratio: Cash and cash equivalents / Current Liabilities

The cash ratio measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities. This ratio shows how quickly a company can settle current obligations.

2)    Leverage ratios

Companies often use short and long-term debt to finance business operations. Leverage ratios measure how much debt a company has. Molson Coors Beverage Co. , the maker of Coors Light and Miller Lite beer for instance, had been saddled with debt, after an acquisition in the industry according to the Wall Street Journal. Its CFO Tracey Joubert signaled to the market the company’s plans “reduce its leverage ratio to below 3 times by the end of this year.” The types of leverage ratio to consider are:

Debt ratio: Total Debt / Total Assets

The debt ratio measures the proportion of debt a company has to its total assets. A high debt ratio indicates that a company is highly leveraged.

Debt to equity ratio: Total Debt / Total Equity

The debt-to-equity ratio measures a company’s debt liability compared to shareholders’ equity. This ratio is important for investors because debt obligations often have a higher priority if a company goes bankrupt.

Interest coverage ratio: Operating income / Interest expenses

Companies generally pay interest on corporate debt. The interest coverage ratio shows if a company’s revenue after operating expenses can cover interest liabilities.

3)   Efficiency ratios

Efficiency ratios show how effectively a company uses working capital to generate sales. For instance an analyst reported that Seattle-based bank Washington Federal’s company’s efficiency ratio was 58.65%, down from 59.02% recorded a year ago. A fall in efficiency ratio indicates improved profitability. There are several ways to analyze efficiency ratios:

Asset turnover ratio: Net sales / Average total assets

Companies use assets to generate sales. The asset turnover ratio measures how much net sales are made from average assets.

Inventory turnover: Cost of goods sold / Average inventory

For companies in the manufacturing and production industries with high inventory levels, inventory turnover is an important ratio that measures how often inventory is used and replaced for operations.

Days sales in inventory ratio: 365 days / Inventory turnover ratio

Holding inventory for too long may not be efficient. The day sales in inventory ratio calculates how long a business holds inventories before they are converted to finished products or sold to customers.

Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average Accounts Payable

The payables turnover ratio calculates how quickly a business pays its suppliers and creditors.

Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period (or year)

This ratio shows how many days it takes a company to pay off suppliers and vendors. A lower days payables outstanding implies that a business is letting go of cash too quickly and may not be taking advantage of longer credit terms. On the other hand, when the DPO is too high, it means a company delays paying its suppliers, which can lead to disputes.

Receivables turnover ratio: Net credit sales / Average accounts receivable

Accounts receivables are credit sales made to customers. It is important that companies can readily convert account receivables to cash. Slow paying customers reduce a business’s ability to generate cash from their accounts receivable.

The receivables turnover ratio helps companies measure how quickly they turn customers’ invoices into cash. A high receivables turnover ratio shows that a company quickly generates cash from accounts receivables.

4)    Profitability ratios

A business’s profit is calculated as net sales less expenses. Profitability ratios measure how a company generates profits using available resources over a given period. Higher ratio results are often more favorable, but these ratios provide much more information when compared to results of similar companies, the company’s own historical performance, or the industry average. Some of the most common profitability ratios are:

Gross margin: Gross profit / Net sales

The gross margin ratio measures how much profit a business makes after the cost of goods and services compared to net sales. Comparing companies can be illustrative – such as finding that Home Depot has a 33.6% gross profit margin versus Walmart’s 25.1%.

Operating margin: Operating income / Net sales

The operating margin measures how much profit a company generates from net sales after accounting for the cost of goods sold and operating expenses.

Return on assets (ROA): Net income / Total assets

Companies use the return on assets ratio to determine how much profits they generate from total assets or resources, including current and noncurrent assets.

Return on equity (ROE): Net income / Total equity

Shareholders’ equity is capital investments. The return on equity measures how much profit a business generates from shareholders’ equity. For instance a company with a declining ROE could be seen as having more risk than a company in the same industry with an increasing ROI.

5)   Market Value ratios

Market value ratios are used to measure how valuable a company is. These ratios are usually used by external stakeholders such as investors or market analysts but can also be used by internal management to monitor value per company share.

Earnings per share ratio (EPS): Net earnings / Total shares outstanding

The earnings per share ratio, also known as EPS, shows how much profit is attributable to each company share.

Price earnings ratio (P/E): Share price / Earnings per share

The PE ratio is a key investor ratio that measures how valuable a company is relative to its book value earnings per share.

Book value per share ratio: Total Equity – Preferred Equity / Total shares outstanding

A company’s common equity is what common shareholders own after all liabilities and preference shares have been settled from total assets.

The book value per share measures the value per share for common equity owners based on the balance sheet value of assets less liabilities and preference shares.

Dividend yield ratio: Dividend per share / Share price

The dividend yield ratio measures the value of a company’s dividend per share compared to the market share price.

When companies pay out dividends to shareholders, the value of dividends received for each share owned is known as the dividend per share. Shareholders and analysts compare the dividend per share to the company’s share price using the dividend yield ratio.

Best Practices For Using Financial Ratios

Financial ratios help senior management and external stakeholders measure a company’s performance. These best practices will drive effective decision-making.

● Compute financial ratios with accurate financial numbers

● Compare ratios across periods to identify performance trends

● Use relative competitor and industry benchmarks to measure performance

● Calculate ratios using balance sheet averages where applicable

● Interpret financial ratios correctly to support key business decisions

● Calculate and analyze ratios using the balance sheet, income statement, and cash flow statement to get a holistic view of the business’s performance

Final Thoughts

Financial ratios are good key performance indicators used to measure a company’s performance over time compared to competitors and the industry. Calculating accurate financial ratios and interpreting the ratios help business leaders and investors make the right decisions.