### 5 Simple Financial Ratios and What They Mean

date: 2021-06-13 21:33:14

Either you are the owner of a company or investing in one, the same story applies “The numbers tell the story”

When it comes to analysing a company, there are various levels of details. The basic level is to understand revenue, expenses, assets, liabilities and the relationship of all of the aforementioned with your cash flow. The second level though is to understand the health of a company.

So, what are financial ratios? They are simply figures extracted from a company’s income statement, balance sheet and cash flow and compared to one another in order to provide a clear financial picture of a company’s earnings strength, liquidity, profitability or debt usage.

The following are 5 important financial ratios you have to know:

Return on equity (ROE)

Calculation: Net income / Shareholders Equity

ROE is considered to be one of the most important financial ratios, as it allows you to compare a company’s return relative to the amount invested. This could assist you in understanding the return percentage and compare it to other alternative investments.

Gross profit margin

Calculation: Gross Profit / Revenue

As a rule of thumb, “margin” means dividing by revenue. Gross profit means Revenue minus direct expenses. So for example, if you bought an apple for 2 US\$ and sold it for 3 US\$ your gross profit is 1 US\$, while, your gross profit margin is 33.3%.

Gross profit margin is also very important in understanding because if you a company’s gross profit margin is negative, that means that the current business model will never be profitable. For example, let us assume you sell oranges for 5 US\$, however, each orange actually costs 6 US\$, while, your other expenses are 500 US\$, that means that even if you sell one million oranges you will never actually going to cover your expenses. In fact, every orange you sell actually means you lose even more than 500 US\$. How high your gross profit margin should partly depend on how high your other expenses are.

EBITDA margin

Calculation: EBITDA / Revenue

EBITDA means Earnings (i.e net profit) before interest, taxes, depreciation and amortization. This is also an important ratio, because (continuing on the example above), not only does it capture how much the cost of the oranges sold were, but also it takes into consideration the 500 US\$ that you pay.

Current ratio

Calculation: Current assets / current liabilities

Current ratio basically reveals if the company is able to pay its current liabilities using its current assets. Current assets mainly include cash, inventory and accounts receivables. On the other hand, cash liabilities mainly include accounts that are due to be paid within one year, like accounts payable and debt payments. In a nutshell, this means that the current ratio simply implies that if you collected all your receivables and sold all your inventory and add both of these items to your cash balance, will you have enough cash to pay out all your liabilities? As a rule of thumb, if this ratio is below one, then there is definitely a cash flow problem in the short term.

Financial leverage

Calculation: Total capital employed / Shareholders equity

Most business usually revert to borrowing in order to operate.

Financial leverage is an important ratio that reveals the degree in which a company uses debt (i.e. borrowed money).

Total capital employed is the accounting value of all interest-bearing debt plus all owners’ equity. So as a quick example, if you have 100 US\$ in debt and the company invested 100 US\$ from its shareholders, that means your financial leverage would be 2x (200 / 100).

Usually, the higher this figure the riskier the company is. This is because there is more debt to be repaid. However, it should be noted that this depends on the sector and the country in which your company is operating in. Additionally, the loan terms (for example the interest rate of the loan) are also important factors that should be taken into consideration when looking at this ratio.

Summary

Usually if you are planning to invest in a company, it is best to take into consideration the last three historical years of these ratios. This would be enough to tell you the direction and trends of the company. These ratios can also be compared to other comparable companies so you can understand the relative strength of a company.

However, if you are analysing these figures for your own company for internal purposes, these figures should be much more thoroughly analysed and understood in order to improve them, if possible.

Do you need to value your company or find out the financial feasibility of your new idea? Check out Front Figure. It is quicker and more cost effective compared to other traditional methods.

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