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Importance of Financial Statement Ratios

The fourth quarter is a time when many Denver and Colorado companies focus on closing the books and generating needed financial reports. The information is needed to assess the current year’s performance, but is also important for budgeting, cash flow forecasting and more. In addition, it can also be useful when improving performance. To accomplish this requires selecting financial and operational metrics and regularly evaluating against a dashboard of stated goals.

Depending on the size and type of organization, the metrics measured will likely change. Some might focus on the profit and loss statement which provides details about sales and profitability. Others may prefer the balance sheet which provides insight into liquidity, borrowing, and assets. In either case, both provide important information to improve overall performance. To help clients, prospects, and others, WhippleWood CPAs has provided a summary of the key details below. 

Financial Statement Ratios Overview

There are dozens of ratios which can be used to evaluate the financial performance of a business. However, many of these are used by businesses in specific industries or those seeking detailed information about one aspect of operations. To keep it simple, there are four basic ratio categories including liquidity, activity, profitability and leverage ratios. They are each used to measure different types of information, including:

  • Liquidity Ratios – These measure the ability of a company to pay its debt. These ratios determine how quickly assets can be converted and used to pay debts. This information is often assessed by creditors before offering loans or lines of credit to a business.
  • Activity Ratios – These measure how efficiently the company is employing its capital or assets. These ratios are very valuable when used to compare performance over time or against peers in the same industry.
  • Profitability Ratios – These measure the ability of an organization to generate earnings relative to revenue, costs, and shareholder equity. This provides the most value when used as a comparison tool rather than as stand-alone metrics.
  • Leverage Ratios – These measure a company’s debt relative to another metric such as equity or cash flow. They reveal how much capital comes from debt and whether it can be used to meet certain obligations.

Commonly Used Ratios

There are dozens of ratios used by companies for a variety of reasons and circumstances. However, for those getting started there are a small number of ratios which can offer significant insight into financial performance, including:

  • Current Ratio – This liquidity ratio is measured by taking current assets and dividing it by current liabilities. If the result is a low number (less than 1), steps can be taken to improve it such as managing accounts receivable more closely, reducing monthly expenses, or opening a line of credit. Pay special attention to the number of days Accounts Receivable and Accounts Payable are outstanding and set goals to improve these numbers.
  • Debt to Equity Ratio – This leverage ratio determines the weight of total debt and financial liabilities against total shareholder equity. It measures how a company’s capital structure is titled either towards debt or equity financing. A good score is between 1 to 1.5 but there are variations based on industry served and other factors.
  • Gross Margin Ratio – Also known as gross profit margin, this profitability ratio compares gross profit against the revenue of the business. It is calculated by subtracting gross profit from cost of goods sold and dividing the resulting value over total revenue. The ratio measures the percentage of each dollar of revenue the company keeps as gross profit. If the margin is decreasing over time, it could mean that suppliers are increasing the cost of their services faster than you are increasing pricing to end customers.  Or it could mean you aren’t using suppliers efficiently.  Comparing multiple suppliers and monitoring prices can help improve margins.
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Financial statement ratios can provide additional insight into an organization’s performance useful for informing management decisions. There are dozens of ratios to use so it is important to select the proper mix based on where management wants to evaluate. If you have questions about the information outlined above or need assistance creating your own performance dashboard, WhippleWood CPAs can help. For additional information call 303-989-7600 or click here to contact us. We look forward to speaking with you soon.