In an era of big data, every business has access to more information that they can possibly review or use. It can be very difficult to sort through all of the available information and find data that is useful. To make timely business decisions, you need a set of financial tools that you can quickly locate and review. Financial ratios are one of those tools. Like the instrument panel in your car, you can glance at the ratios to see how your business is performing.
One set of ratios measures how well you use assets to make money in your business. After all, the reason you purchase machinery, equipment, or raw materials is to use them to make money. Asset utilization ratios tell you how well you’re using those assets.
Raising money to run your business
Finance has become complicated, but there are still two basic ways to raise money for your business. You can borrow money, which means that the other party is a creditor. Your firm pays interest on the amount borrowed and repays the debt based on a schedule.
Companies also raise money by selling ownership, which means that the investor is an owner. Owners may receive a dividend or some other payout from company profits. They also hope to see the value of their equity investment increase.
The combination of debt and equity that you issue is referred to as your firm’s capitalization. If your firm has a history of generating earnings each year, you’ll have an easier time issuing debt. That’s because your business has available earnings to make interest payments on debt and to repay the principal amount borrowed.
Start-up companies, and businesses that do not generate consistent earnings, will have a tougher time issuing debt. They will not be able to borrow as much money as other firms and they will have to offer lenders a higher interest rate.
Many of these companies issue equity instead. A stock buyer understands that the issuer does not generate consistent earnings, but may be able grow rapidly and become profitable. These equity investors are comfortable with taking more risk to benefit from a higher stock price over time.
Debt to equity ratio
The debt to equity ratio is (Long-term debt) / (Stockholder’s equity). This ratio tells you how much debt you have as a multiple of your equity. If the ratio increases, that may be a red flag. Say, for example, that the ratio increases from 2/1 to 4/1. That means that your debt is now four times your equity. You must pay a lot more interest and plan to repay a growing amount of principal. Can your company generate sufficient earnings to make those payments?
Interest coverage ratio
This ratio tells you how your operating income compares with your interest expense. The ratio is (Operating income before taxes and interest) / (Interest expense). Operating income refers to the earnings you generate from your day-to-day business activities. It excludes any one-time or unusual sources of income, such as selling an asset. This is an asset utilization ratio, because it compares the income you generate with the interest expense you incur to buy assets.
Assume, for example, that your operating income before taxes and interest is $30,000 and that your interest income is $6,000. That means that 20% of your operating income goes toward interest on debt. If you take on more debt, a larger percentage of your income will go toward interest payments. This ratio helps you judge whether or not you have sufficient income to make those payments.
Return on assets
This ratio tells you how much income you generate for every dollar of assets. There are several versions of the formula, but this version is the most common:
Return on assets (ROA): [(Net income) + (Interest expense) * (1- Tax rate)] / (Average total assets)
The formula assumes that the interest expense you incur represents money borrowed to buy assets. On your business tax return, you’re able to deduct the interest expense. As a result, this formula adds the tax deduction for interest expense back to net income. Once you calculate that total amount in the numerator, you divide by average total assets.
Your goal here is to try and maximize the amount of net income you make for every dollar in assets. That approach will increase the ratio, and indicates that you’re using assets more effectively.
Operating profit margin
This ratio tells you the amount of profit you earn on every dollar of sales. Note that this ratio specifically addresses operating profit. Operating profit is the consistent, reliable profit you hope to generate each month and year. If you manufacture and sell jeans, for example, operating profit is what you earn from making and selling jeans. If you happen to sell a building for a gain, that is non-operating profit.
The formula is (Operating profit) / (Sales). Assume that your hardware store earns $2 on the sale of a $10 hammer- a 20% profit margin. You can use profit margin to compare the profit of one product with another, regardless of sale price. Let’s say that your store also sells a $300 lawn mower, which generates a $45 profit (15% profit margin). You earn more revenue by selling a lawn mower, but you earn a higher profit margin when you sell a hammer. A higher sale price does not necessarily mean a better profit margin.
If you’re a manufacturer, it’s important to pay attention to gross margin. Gross margin is simply sales less cost of sales. Using the jean manufacturer as an example, assume that you sell a pair of jeans for $80 and that your cost of sales is $50. The gross profit is $30.
Gross profit is not your net income, because you must subtract other expenses that are not directly related to production. For example, you’ll incur marketing, selling and administrative costs that are not related to manufacturing the jeans. Once these indirect costs are subtracted from gross margin, you can compute your net income.
This ratio is important, because cost of sales is typically the largest component of costs for a manufacturer. If your cost of sales in increasing, you may look at your vendor agreements and consider ordering materials from another (cheaper) supplier.
Invest the time to put together a useful list of financial ratios for your business. Make sure that your accounting software allows you to pull up those ratios whenever you need them. Use these critical ratios to keep your business on track.