Financial ratios are a powerful tool used by creditors, analysts, investors, and managers to assess a company’s financial performance.
Specifically, financial ratios are used to measure the efficiency, profitability, flexibility, and sustainability of a business. They’re a simplified way of making sense of complicated financial transactions.
These ratios can be as simple as taking one item on the balance sheet, like Total Debt, and dividing it by another, like Total Assets. We can then use the outcome to determine certain conclusions, like whether we have too much, too little, or just the right amount of debt — no need to understand the underlying accounting (although it wouldn't hurt).
Each metric, and how you interpret its performance, is often context specific (i.e. industry, the line of business, capital structure, growth stage, etc.). It's not important to understand them all. You only need to use a few to track progress toward meaningful goals.
Financial ratios have many uses, but for this post, we’re going to focus on their utility as a management tool.
Financial statements are difficult enough to interpret on their own. Unless you understand the intricacies of accounting and finance, it can be hard to see how performance on the income statement affects the balance sheet and vice versa. Financial ratios demonstrate these relationships in a simple, easy to digest manner.
Using a single metric, we can compare information from multiple financial statements and understand what it means for the business.
Ratios can act as leading indicators for financial improvement and deterioration. Especially when monitoring trends over time, so it's important to keep an eye on key ratios as they change. They can tell you a lot about how management is running the business, and whether it’s on track to meet financial goals.
Ratios level the playing field for companies of all sizes. They provide a standard format to compare with industry averages or other companies in the same sector. Similar businesses often have the same capital structures and investment requirements, so it's easy to compare yourself to peers, even if they're 100x larger.
There are plenty of metrics to choose from, and they cater to many different audiences, so it’s important to use some framework for selecting specific ratios.
Generally, it’s a good idea to choose ratios that support specific goals or strategies.
Want to keep an eye on how the company uses debt? Choose an appropriate leverage ratio. Want to increase profitability? Identify metrics for key profit margins.
We’ll discuss a few of these measures shortly, and they all fall into one of the following categories:
• Profitability Ratios: tell us about management’s performance in conducting operations
• Efficiency Ratios: show us how the company uses assets to generate growth
• Liquidity Ratios: measure the company’s ability to pay current obligations
• Leverage Ratios: reflect the company’s use of debt financing
We’ve chosen ratios that focus mostly on the topic of cash management.
My reason for emphasizing cash lies in a lesson learned from “The Outsiders” by William Thorndike (highly recommended). In the book, Thorndike describes how some of the most successful CEO’s in history paid particular attention to cash metrics. They favored these measures even though their peers focused on things like revenue and earnings (i.e. vanity metrics).
In the end, each of the CEO’s beat their peers and the market by astronomical margins. Not a bad group to emulate. It’s also a powerful reminder not to blindly follow the crowd.
There are many variations for calculating some of the metrics below, so as a general rule of thumb, we’ll use the more conservative measures since they tend to be more appropriate for non-publicly traded companies.
Cash runway is probably best known in the startup world. It tells us how many months the business can sustain itself with available cash. Runway is only relevant in months, or periods, where a company experiences negative cash flow, and we can see why this is the case by taking a look at the equation below.
Cash balance / Burn Rate
Cash Balance: the amount of money in the bank
Burn Rate: how quickly the business is spending money in excess of income (negative net cash flow)
For example: if we have a Cash Balance of $30,000 and a Burn Rate of -$5,000, our Runway is 6 Months.
As we can see, the denominator (Burn Rate) is defined by negative cash flow. If cash flow is positive, there is no burn rate, and cash runway would be infinite. We can similarly say the business can go on forever with positive cash flows. Seems logical.
A low cash runway tends to be negative. It means you’ll run out of money soon based on current trajectories. In the example above, we only have six months of cash at current rates. Whether this is enough time to turn the business around will depend upon individual circumstances. Possible solutions include reducing spend, increasing cash inflows, selling assets, or seeking external funding.
Alternatively, having a high cash runway is generally viewed positively. Where cash runway falls short is that it can’t tell you how high is too high, because it only provides a single measure once we reach cash flow positivity: “infinite.”
Cash Ratio is the conservative liquidity measure when compared to more popular metrics like the Current and Quick Ratios. All three of these metrics depict a company’s ability to pay current liabilities.
Unlike the other two Ratios, the Cash Ratio only includes money the business has on hand, which is what makes the measure more conservative. The Current and Quick ratios include non-cash assets like receivables, inventory, and prepaid expenses, which may eventually convert to cash, but most small businesses would find it hard to pay current bills with these assets.
Cash & marketable securities / current liabilities
Cash & Marketable Securities: Cash in the bank, and assets that are easily converted into cash (i.e. publicly traded stocks)
Current Liabilities: Amount owed to creditors within the next 12 months
A ratio of 1 means the business can pay all current liabilities with available cash.
Measurements of less than one mean the business has more current liabilities than it can service with current cash. If the cash ratio is too low, it could be saying the company is overly reliant on receivables and future sales to pay current bills. This scenario would be a delicate balancing act that points to a more reactive approach to cash management.
Generally, a higher cash ratio is better. It means the business can pay current liabilities comfortably with available cash. However, if the cash ratio is too high, it could mean the company isn’t effectively putting money to work for future growth.
Sales don’t matter if the cash isn’t collected, which is what Days Sales Outstanding is all about. It tells us how many days it takes the business to collect money from customers.
DSO is an excellent ratio because it’s a kind of “leading indicator.” If a large number of customers are taking longer to pay invoices, it could be pointing to an industry slowdown.
(Accounts Receivable / Net Credit sales) x Days in Period
Accounts Receivable: Total receivables for the period
Net Credit Sales: Total dollar amount of sales on credit less returns and discounts
Days in Period: Number of days the calculation spans. If it’s a monthly statement, we use the number of days in that month.
For example: If we had $250,000 in accounts receivable and $125,000 in credit sales for December, then Days Sales Outstanding would be 62 days. Meaning, at current rates it would take 62 days to collect the $250,000 in receivables.
A high reading could indicate customers are struggling to pay their bills, company credit policies aren’t stringent enough, or there are other inefficiencies delaying the collection of invoices.
Lower ratios are generally good a good thing. If taken to an extreme, it could mean company credit policies are too strict, and it’s leaving potential sales on the table.
Similar to Days Sales Outstanding, Days Payables Outstanding tells us how many days it generally takes to pay key vendors. This ratio focuses more on important bills the company needs to pay to stay in business.
(Accounts Payable / Credit Purchases) * Days in Period
Accounts Payable: Total Payables for the Period
Credit Purchases: Total Credit Purchases for Period (Cost of Goods Sold often used as a substitute).
Days in Period: Number of days in the period
For example: If we had $100,000 in accounts payable and $115,000 in credit purchases for December, then Days Payables Outstanding would be 36 Days. Meaning, at current rates we’ll pay off the $115,000 in payables in 36 days.
A high number could indicate the company is struggling to pay its bills, which would put it at risk of getting cut off by suppliers.
Lower readings might mean the company isn’t maximizing the use of credit terms or is taking advantage of discounts.
Days Payable Outstanding is even more powerful when used in unison with DSO, which provides a barometer for net cash flow. As a general rule, it’s better to collect money faster than you’re spending it.
Businesses that hold inventory will want to pay special attention to Days Sales in Inventory. It tells us how many days it takes to sell inventory at current levels of sales.
(Ending Inventory / COGS) * Days in Period
COGS (Cost of Goods Sold): Measures the direct costs attributed to the production and delivery of goods sold
Inventory: The amount of inventory on hand
For Example: If a business has $50,000 in inventory and $75,000 in COGS for January, then Days Sales in Inventory would be 21 days. Meaning, current inventory can sustain the business for 21 days at these rates.
Lower levels of DSI means we have less cash tied up in inventory. In financial speak, we could say inventory is more “liquid,” which means we’re selling it and converting it into cash quickly. Industries with stock that goes stale should naturally have lower DSI. You wouldn’t want to have 45 days of inventory for a product that spoils in 14 days. If taken to an extreme low DSI could mean the business isn’t ordering enough inventory or is having trouble securing sufficient inventory to meet demand.
High DSI indicates a lack of demand. The business may be ordering too much inventory, which isn’t good because cash is then tied up in inventory when it could be available for use in other areas of the business.
Today’s your lucky day. You’re getting three ratios for the price of one. If you’re in public, please try and contain your excitement.
Profit margins are taken exclusively from the income statement and measure the company’s efficiency in producing cash from different levels of operations.
Gross Profit Margin represents the profitability resulting from pricing decisions and product costs. It tells us the percentage of each sales dollar we keep after covering the costs of delivering goods and services to customers.
Operating Profit Margin tells us about the company’s profitability after “management-controlled” costs. These items tend to be viewed as more discretionary as they represent the costs of supporting the business.
Net Profit Margin is the firm’s overall ability to convert sales into profit. It tells us the percentage of each sales dollar we keep after deducting all costs.
Gross Profit Margin: (Gross Income / Revenue) x 100
Operating Profit Margin: (Operating income / revenue) x 100
Net Profit Margin: (Net Profit / Revenue) x 100
Revenue: Total proceeds from the sale of goods and services
Gross Income: Profit left over after deducting the direct costs of providing goods or services to customers, also known as the cost of goods sold (COGS)
Operating Income: Profit left over after deducting COGS and all operating expenses
Net Income: Profit left over after all costs and expenses, including taxes and interest
Higher margins could mean the business has a competitive advantage in quality, perception, branding or some other area. It also means the business can better absorb external shocks, which makes it more flexible when adapting to new market conditions. On a fundamental level, higher margins mean the company is efficiently producing future cash from operations.
Lower margins are generally bad and could mean the company is more at risk in the event of market fluctuations. Especially if low margins are taking place at the Gross Profit level. However, low margins could also mean the business is reinvesting more heavily in areas that will produce future growth (think Amazon).
The Debt Service Coverage Ratio is an excellent metric for businesses using debt financing. It measures the company’s ability to pay debt with cash generated from operations.
This ratio is often analyzed by creditors to assess creditworthiness.
Unlike the Interest Coverage Ratio, which only considers a company’s ability to pay the interest on debt, the Debt Service Coverage Ratio considers all expenses related to debt. This characteristic makes it more informative since businesses don’t usually pay interest only.
Debt Service Coverage Ratio = Net Operating Income / Total Debt Service Costs
Operating Income: Profit left over after deducting COGS and operating expenses
Total Debt Service Costs: Interest, principal, and other obligations
A reading of 1.3 would mean 30% of profits remain after servicing debts.
Higher ratios are considered a good thing, but they could also indicate that the company isn’t utilizing enough leverage for growth.
If the debt service coverage ratio is too low, it means the business is struggling to maintain current debt levels. A reading of less than one indicates the company has to use savings to pay debts, which is not sustainable.
The Contribution Margin Ratio tells us the percentage of each sales dollar available to cover fixed costs and expenses. It is derived from the contribution margin, which is the amount we have left over after deducting variable costs from sales revenue.
In a way, the contribution margin ratio tells us what the cap on profitability is. Variable costs theoretically grow alongside sales volume, and fixed costs stay the same, so the company won’t be able to achieve profitability any higher than the contribution margin ratio.
One cool thing about the contribution margin ratio is that we can use it to find out the breakeven point for a business. All we have to do is divide total fixed costs by the ratio.
(Sales - Variable Costs) / Sales
Sales: Total proceeds from the sale of goods and services
Variable Costs: Costs that vary depending on levels of output (sales)
Sales - Variable Costs = Contribution Margin
A higher contribution margin ratio tends to be a good thing. Either, costs are low, or the selling price is high. Higher margins also reduce a company’s break-even point, leaving more money to cover fixed costs.
Lower readings are less advantageous. It could mean the costs of producing revenues are too high, or prices are too low. The only way to increase margins would then be to raise prices, decrease variable costs, or both.