Why Are Financial Ratios Important?

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by Brian J. Eagan, CPA  | Selden Fox

Managing a company, organization or enterprise can be a challenging task. Along with the day-to-day activities of running the company, it’s vital to evaluate performance on a regular basis to ensure success. Analyzing the financial and operational condition of the organization to understand strengths and weaknesses helps leadership determine where improvements or changes can be made. The good news is that company performance information can easily be gleaned through financial ratios. Financial ratios use information contained in the financial statement to evaluate performance effectiveness in key areas. Here we provide a summary of key ratios, what they measure, and what value they can bring to your organization.

Benefits of Ratios

Financial ratios are important tools for quantitative analysis. Certain ratios are available to evaluate both short- and long-term financial and operational performance, making them useful at identifying trends in the business and providing warning signs when it may be time to make a change. There are also specific ratios that can measure important variables essential to one industry or another. By evaluating particular ratios, a business can benchmark itself against similar companies and understand its strengths, weaknesses, threats and areas of opportunity.

Common Ratio Types

While there are dozens of ratios to consider here are some common ones many companies include in their annual or quarterly assessment.

  • Liquidity Ratios – These ratios are designed to indicate a company’s ability to manage short-term financial obligations, including short-term debt. The ratio is calculated by comparing the company’s liquid assets (those that can be turned into cash easily) against current short-term liabilities. The higher the coverage, the greater the ability to cover short-term debt. By contrast, lower coverage means a decreased ability to handle short-term debt. When a company is having trouble meeting short-term financial obligations, it could very well be an indicator of trouble, and day-to-day operations could be impacted. Examples of liquidity ratios include current, quick, cash, and days of working capital ratios.
  • Leverage Ratios – Leverage ratios are designed to indicate the long-term health of a business. Their primary role is to indicate how much capital comes from debt, such as loans and credit, and to determine the ability of a company to meet its long-term financial needs. Leverage ratios are important because they illustrate how much a company relies on the mixture of debt and equity to maintain operations. Examples of leverage ratios include debt to equity, long-term debt to capitalization, and total debt to capitalization ratio.
  • Profitability Ratios – Profitability ratios indicate a company’s ability to generate earnings against cost during a given period. The ratios reveal how well a company is making use of its assets to generate a profit. Profitability ratios are generally used to determine how profitable a company is in one period of time over another period of time (year, quarter or month). Examples of profitability ratios include profit margin, return on assets, and return on equity.
  • Asset Management Ratios – Asset management ratios attempt to determine how well a company is using its assets to generate sales. The information provided by these numbers is often useful in offering insight into the success of a company’s credit policy and inventory management strategy. Examples of asset management ratios include inventory turnover, days sales are outstanding, receivables turnover, and total assets turnover.

Contact Us

Ratios are an important assessment tool that owners and business leaders can use to quickly assess organizational performance. The information revealed through these ratios and the ability to assess changes in these ratios over time provides the opportunity to make needed changes to enhance company vitality. If you have questions about financial ratios or need assistance with an audit, tax, or accounting issue, Selden Fox can help. For additional information, please call us at 630.954.1400, or click here to contact us.

Brian J. Eagan, CPA

Brian Eagan specializes in providing high level interim CFO and Controller work for small to medium size businesses, including non-profit and local government agencies. In this role, Brian makes himself highly accessible to clients by phone and e-mail, in addition to appreciating the importance of performing some of these services onsite at clients’ offices.