Blog | Entrepreneurship

8 Key Financial Ratios to Know about a Business’ Health

Does your toolkit include these key financial ratios to become a sophisticated business owner?

Summary

• Understanding the various financial ratios puts you ahead of many other investors

• Financial ratios help to draw fact-based conclusions regarding the health of a business

• To have a clear picture of the potential of a business, use these 8 key financial ratios

---

Whether you’re investing in a business, the owner of one, or thinking about starting one, 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.

When it comes to reading a financial statement, there are various levels of sophistication. As a baseline, you should be able to understand income, expenses, assets and liabilities, as well as the relationship between these and your cash flow.

But to become a sophisticated business owner and investor, you need to grow your knowledge base and understand even more advanced financial concepts to know the health of either your business or one you’re planning on investing in.

What are key financial ratios?

When it comes to understanding the health of a business, there are key ratios that you can use to determine the financial health of a business.

As Investopedia defines them, “Key ratios take data from the subject company's financial statements such as the balance sheet, income statement and statement of cash flows. Items on these statements are compared with other items to produce ratios that represent key aspects of the company's financial picture such as liquidity, profitability, use of debt and earnings strength.”

These key ratios are not difficult to calculate, but many people don’t know them. Just by reading this post, you put yourself well above many investors in your ability to evaluate the health of a business.

The following are eight key financial ratios you need to know.

Key financial ratio #1: Gross margin percentage

Calculation: Gross margin percentage = Gross margin / sales

Gross margin is sales minus the cost of goods sold. So, if you sell $100 in bananas and they cost you $75, your gross margin is $25.

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. In this example it would be $25/$100, which equals a gross margin percentage of .25 or 25%.

Why is gross margin percentage important?

Rich dad used to say, “If the gross isn’t there, there’ll be no net.” If, for instance, you’re investing in a business that has a high gross margin percentage but isn’t making money, you can look to see if it is simply being mismanaged. Cleaning up the operations could mean a highly profitable business once fixed.

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.

Key financial ratio #2: 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, which are out of the business owner’s control.

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).

It factors in the costs of a business that can be controlled and gives you the sense of how well a business is being managed. A highly variable EBIT can indicate a risky business. A stable one could indicate a well-managed and predictable one.

Why is net operating margin important?

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!

Key financial ratio #3: Operating leverage

Calculation: operating leverage = contribution / fixed costs

Every business has fixed costs that must be accounted for in the overall cost structure. The percentage of fixed costs relative to all costs is called “operating leverage,” and is calculated by dividing contribution, which is the gross margin (sales minus cost of goods sold) minus variable costs (all costs that are not fixed costs that fluctuate with sales), by fixed costs.

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.

Why is operating leverage important?

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 an indication of profit. Again, the higher the better.

If a business has a low operating leverage, it may be worth seeing if another lever like operating margin is being under leveraged. Increasing gross margin through things like price increases could lead to a higher operating leverage.

Key financial ratio #4: Financial leverage

Calculation: financial leverage = total capital employed / shareholder’s equity

Almost every business needs to borrow money in order to operate.

Financial leverage is a key financial ratio that refers to the degree a business uses borrowed money. Total capital employed is the accounting value of all interest-bearing debt 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).

What is financial leverage important?

As in life, you don’t want a business to be over leveraged. The higher a business’s financial leverage, the riskier it is because there is more debt to be repaid.

That being said, 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.

Key financial ratio #5: Total leverage

Calculation: total leverage = operating leverage x financial leverage

Total leverage is calculated by multiplying the operating leverage (key ratio #3) by the financial leverage (key ratio #4). If you are the business owner, and therefore on the inside, you have at least partial control of your company’s total leverage.

Why is total leverage important?

Total leverage represents the total risk that a company carries in its present business. Total leverage tells you the total impact a given change in the business should have on the equity owners.

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.

Key financial ratio #6: Debt-to-equity ratio

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.

Why is debt-to-equity ratio important?

Generally speaking, the lower the debt-to-equity ratio, the more conservative the financial structure of the company. The more conservative the financial structure of a company, the less risk there is. Now, less risk isn’t always what an investor is looking for, so you’ll have to determine your own level of risk. This key ratio will help you know if a potential investment is meeting or exceeding that level of acceptable risk.

Key financial ratio #7: Quick and current ratios

Calculation: quick ratio = liquid assets / current liabilities

Calculation: current ratio = current assets / current liabilities

Quick and current ratios are both designed to tell you whether or not the company has enough liquid assets to pay its liabilities for the coming year.

A quick ratio takes liquid assets into account only. This means things like cash, receivables, and securities. Unlike the current ratio, it doesn’t take into account things like inventory, which may take time to liquidate in the event of a need to pay off liabilities. The type of business you’re looking at will determine which of the ratios are best to use. For instance, a business with a history of high inventory turnover might be better suited for a current ratio while one that moves its inventory slowly is better served by the quick ratio.

Why are quick and current ratios important?

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 hand, a current ratio and a quick ratio of 2 to 1 or higher is more appropriate.

Key financial ratio #8: Return on equity

Calculation: net income / average shareholder’s equity

Return on equity is often considered one of the most important key financial ratios. It allows you to compare the return a company is making on its shareholders’ investments compared to alternative investments.

Why is return on equity important?

The whole point of investing in and owning a business is to make money. If a business has a low return on equity, it’s not worth your time. A lot of factors go into return on equity, however, so it’s important to utilize all these ratios to see if there are hidden areas of opportunity in a business. For instance, a mismanaged business could have lots of seemingly bad numbers, but in the right hands it could be a goldmine.

What do these key financial ratios indicate?

Rich dad taught to always consider these figures over the course of at least three years. 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.”