Understanding Financial Ratios and How to Use Them for KPI Tracking

Introduction

Financial ratios are analytical tools commonly used by businesses and financial analysts to obtain insight into the financial performance of a company. They are typically derived from information that is presented in a company’s financial statements. By using financial ratios, businesses can access essential information such as the health of a company, its financial strength, value, liquidity, and much more.

The use of financial ratios to track performance can be beneficial to businesses as they are a quick and efficient way to measure KPI (key performance indicator). Utilizing financial ratios for KPI tracking allows businesses to get a better understanding of their operations and gain insight on aspects such as profitability, risk, asset management, and so on. This blog post will provide an overview of financial ratios, explain how they can be used to measure KPI, and provide some examples.

Operating Margin

Operating margin is a financial ratio that is used to measure a company’s operating efficiency. It is calculated by taking a company’s operating income (earnings before interest and taxes) and dividing by total sales. The resulting number is expressed as either a percentage or a ratio. Operating margin is used by investors and lenders to gain insight into how well a company is managing its costs and generating profits.

Definition

Operating margin is the ratio of operating income to total sales. It is a measure of a company’s efficiency in generating profits from its operating activities. The ratio is expressed as a percentage or a ratio, and is calculated by dividing operating income by net sales. Operating margin is one of the key performance metrics that provide insight into a company’s financial health.

Examples

Operating margins vary by industry, so it is important to research the industry average to get a good gauge of how a particular company is performing. For example, the operating margin for a technology company would likely be lower than that of a manufacturing company. As an example, consider a manufacturing company with $1 million in net sales and $200,000 in operating income. Its operating margin would be 20%, which is calculated by dividing $200,000 by $1 million.

• Industry Average: 10%
• Company A: 20%
• Company B: 15%

In this example, Company A has a higher operating margin than Company B, indicating that it is more efficient in generating profits from its operating activities. In comparison to the industry average of 10%, both companies are performing better than expected.

Cash Flow

Cash flow is an important financial metric that helps an organization to determine the sources of cash and how it is used. On a broad level, cash flow considers the overall direction of money – in or out - during a certain period of time. A key cash flow indicator of a business’s financial health, cash flow informs owners and investors about the availability of funds and how money may be managed within a business.

Definition

Cash flow is a basic but important financial concept. This concept is used in to measure finances, as well as track financial performance, and assess the health of a business. Cash flow is the movement of money in or out of a business. It is important to understand what the sources and uses of cash are in order to plan and manage funds.

Examples

Cash flow has numerous sources, such as:

• Investments
• Borrowed funds
• Payment of debts
• Growth in sales
• Reductions in expenses

In addition to understanding sources of cash, it is important to analyze how cash is used. Examples of cash outflows include:

• Purchasing materials
• Making payroll
• Financing operations
• Investments
• Debt repayment
• Tax payments

4. Debt-to-Equity Ratio

Debt-to-equity (D/E) ratio is a measure of a company's financial leverage, or the degree to which it is funded by debt versus equity. It is calculated by dividing total liabilities by total equity. By looking at a company's D/E ratio, investors and creditors can determine how much of the company's assets are being financed with debt or via equity.

a. Definition

The debt-to-equity ratio is a measure of how much debt a company has compared to its equity and thus how leveraged it is. It is calculated by dividing total liabilities by total equity. If a company has a D/E ratio higher than 1, then it has more liabilities than equity, meaning the company is more leveraged than equity-financed. A company with a D/E ratio lower than 1 is less leveraged and is equity-financed.

b. Examples

Let's look at a few examples. Company A has total liabilities of $1,000,000 and total equity of $500,000. This means that Company A has a D/E ratio of 2 ($1,000,000/500,000). This indicates that Company A is more leveraged than equity-financed. Company B has total liabilities of $400,000 and total equity of $1,000,000. Company B has a D/E ratio of 0.4 ($400,000/1,000,000). Company B is less leveraged than equity-financed.

The D/E ratio is an important tool for investors and creditors to use when evaluating a company. A high D/E ratio is often a warning sign that the company has taken on too much debt and is becoming overleveraged. It also signals to creditors and investors that the company may not be able to pay back its debts. On the other hand, a low D/E ratio may indicate that a company is underutilizing its debt potential.

Profit Ratio

Profit ratio is a financial metric used to analyze the profitability of a business. It is calculated by dividing net profit by total revenue or net sales. This ratio is useful in determining a company’s overall efficiency, as it gives an indication of the company’s financial performance over a given period of time. By comparing the profit ratio to industry averages or other companies in similar industries, it is possible to get a better understanding of the company’s strengths and weaknesses. Additionally, analyzing this ratio over time can provide insights into the progress of a business.

Definition

Profit ratio is defined as the ratio of net profit divided by the total revenue or net sales for the same period of time. It is expressed as a percentage, and can range from -100% to infinity, depending on how much profit or loss the company has made.

Examples

Profit ratio can be used to track a company’s KPI’s, such as its operating profit margin, or return on assets. For example, a company with a net profit of $50,000 and $400,000 in total revenue would have a profit ratio of 12.5%. This means that for every dollar of total revenue, the company earned 12.5% in net profit. Another example is a company with a net profit of $2,000,000 and $20,000,000 in total revenue which would have a profit ratio of 10%. This company earned twice as much profit as the previous example, but because its total revenue is considerably higher, its profit ratio is lower.

Current Ratio

The current ratio is a financial ratio that measures a company's ability to pay off its current liabilities with its current assets. It is used by investors and creditors to assess the liquidity of a company, or in other words, its ability to meet its short-term financial obligations.

Definition

The current ratio is calculated by dividing a company's current assets by its current liabilities. It tells the investor or creditor the number of times in the current period a company can pay its liabilities with the resources available. Generally, a ratio of above one is an indicator of good liquidity. Some lenders even prefer a ratio of two or greater, as it provides more assurance that a company can cover its short-term liabilities if necessary.

Examples

Let's look at a simple example. Consider a company with current assets of $400,000 and current liabilities of $200,000. The current ratio for this company would be 2 ($400,000 divided by $200,000), which indicates that it has twice the number of assets as liabilities and should therefore be able to cover its current liabilities. On the other hand, if the company had a current ratio of 0.5 ($400,000 divided by $800,000), it would suggest that the company is liable to default on its short-term obligations as it has fewer assets than liabilities.

It is important to note that the current ratio alone should not be used as the sole measure to assess the liquidity of a company, as other ratios such as the quick ratio and cash ratio also exist. However, for most organizations, the current ratio is the primary measure of liquidity and should be used to evaluate a company's financial health.

Conclusion

Financial ratios are an important tool which can provide a clear perspective of the business performance. By understanding and interpreting them correctly, they can provide valuable insights into the overall financial health and operations of a business.

Summary of Financial Ratios

A financial ratio is an expression of the relationship between two accounting figures. They provide a comparison of key metrics for financial performance. Most notably, financial ratios can be used to assess the liquidity, leverage, efficiency, profitability, and solvency of a business or organization.

Benefits of Financial Ratios for KPI Tracking

Financial ratios are useful for tracking key performance indicators (KPI). They can provide an objective comparison of performance over time and can also help to identify potential problems that need to be addressed. Furthermore, the use of financial ratios can help to establish a baseline for performance measurement, which can be used to set future goals and objectives.

Monitoring financial ratios is an essential part of managing the financial health and operations of a business. By understanding and interpreting them correctly, they can help to identify areas of improvement and provide valuable insights into the overall financial performance.