8 Key Financial Ratios For Knowing the Health of a Business
Your toolkit for becoming a sophisticated business owner and investor
Whether you’re investing in a business, the owner of one, or thinking about starting one, my Rich Dad’s wise words remain true: “The numbers tell the story.”
In school, your report card is the marker for success. In business, your financial statements are. If you want to be successful in business, you must know how to read a financial statement and how to draw fact-based conclusions about the health and potential of a business.
The following are eight key financial ratios you need to know.
Gross margin percentage
Calculation: Gross margin percentage = Gross margin / sales
Gross margin is sales minus the cost of goods sold. Rich dad used to say, “If the gross isn’t there, there’ll be no net.”
Gross margin percentage is the gross margin divided by sales, which tells you what percentage of sales is left after deducting the cost of the goods sold.
How high the gross margin percentage needs to be depends on how a business is organized and the other costs it has to support. For instance, after calculating gross margin percentage, rich dad’s convenience stores still had to pay the clerks, the utilities, the taxes, rent, and a list of other expenses. They also had to have enough left over to give rich dad a good return on his original investment.
Today, if you own an internet business, the potential for high overhead is lowered, so it’s quite possible that you can afford to sell and make a profit with a lower gross margin percentage. But in all businesses, the higher the gross margin, the better.
Net operating margin percentage
Calculation: Net operating margin percentage = EBIT / Sales
This ratio tells you the net profitability of the operations of a business before you factor in your taxes and cost of money.
Earnings Before Interest and Taxes (EBIT) is your sales minus all the costs of being in business, not including capital costs (interest, taxes, and dividends). The ratio of EBIT to sales is called the net operating margin percentage. Businesses with high net operating margin percentages are typically stronger than those with a low percentage. The higher the better!
Operating leverage = Contribution / Fixed costs
Every business has fixed costs that must be accounted in the overall cost structure. The percentage of fixed costs is called operating leverage, and is calculated by dividing contribution by fixed costs.
Contribution refers to the gross margin (sales minus cost of goods sold) minus variable costs (all costs that are not fixed costs that fluctuate with sales). Examples of fixed costs are labor related to full-time employees and most costs related to your facilities. This is what most people call overhead.
A business that has an operating leverage of 1 is generating just enough revenue to pay for its fixed costs. This would mean that there is no return for the owners. Anything over 1 is indication of profit. Again, the higher the better.
Calculation: Financial leverage = Total capital employed / Shareholder’s equity
Almost every business needs to borrow money in order to operate. Financial leverage is a ratio that refers to the degree a business uses borrowed money. Total capital employed is the accounting value of all interest-bearing debt (leave out payables for goods to be resold and liabilities due to wages, expenses, and taxes owed but not yet paid), plus all owners’ equity.
So, if you have $50,000 in debt and $50,000 of shareholder’s equity, your financial leverage would be 2 (or $100,000 divided by $50,000). Each business type has different standards for what a healthy financial leverage is. Other factors, such as cash flow and cost of debt, play a big part in the overall picture of financial health.
Calculation: Total leverage = Operating leverage x Financial leverage
This represents the total risk that a company carries in its present business. Total leverage tells you the total effect a given change in the business should have on the equity owners. Total leverage is calculated by multiplying the operating leverage by the financial leverage. If you are the business owner, and therefore on the inside, you have at least partial control of your company’s total leverage.
If you are looking at the stock market, total leverage will help you decide whether or not to invest in a company. A well-run, conservatively managed American company usually keeps the total-leverage under 5.
Calculation: Debt-to-equity ratio = Total liabilities / Total equity
This one is pretty self-explanatory. It’s the measure of the portion of the whole enterprise (total liabilities) financed by outsiders in proportion to the part financed by insiders (total equity). Most businesses try to stay at a ratio of one-to-one or below. Generally speaking, the lower the debt-to-equity ratio, the more conservative the financial structure of the company.
Quick and current ratios
Calculation: quick ratio = Liquid assets / Current liabilities
Current ratio = Current assets / Current liabilities
Quick and current ratios tell you whether or not the company has enough liquid assets to pay its liabilities for the coming year. If a company doesn’t have enough current assets to cover its current liabilities, it is usually a sign of impending trouble. On the other had, a current ratio and a quick ratio of 2 to 1 is more appropriate.
Return on equity
Calculation: Net income / Average shareholder’s equity
Return on equity is often considered one of the most important ratios. It allows you to compare the return a company is making on its shareholders’ investments compared to alternative investments.
What do these ratios tell me?
Rich dad taught to always consider at least three years of these figures. The direction and trends can tell you a lot about a company and its management, and even its competitors.
Many published company reports do not include these ratios and indicators. A sophisticated investor learns to calculate them when they aren’t provided. However, these cannot be used in a vacuum. They are indicators, but they must be considered in conjunction with analysis of the overall business and industry. By comparing three-years worth of data with that of other companies in the same industry, you can quickly determine the relative strength of a company.
While the ratios may appear complicated at first, you will be amazed at how quickly you can learn to analyze a company. One fun exercise is to download the financial statements of public companies and run these ratios yourself. Learn how to find the information you need and see what you can learn.
Remember, these ratios are the language of a sophisticated investor. By educating yourself and becoming financially literate, you too can learn to “speak in ratios.”