There are numerous different financial ratios which can be used to monitor a business, however, in order to provide a simple and meaningful financial analysis, the financial projections template keeps them to a minimum and includes the following four key financial projection ratios, each of which aims to highlight a different aspect of the business.
- Profitability (Net income / Revenue)
- Efficiency (Revenue / Assets)
- Leverage (Liabilities / Assets)
- Liquidity (Current assets / Current liabilities)
Profitability is the ability of the business to generate profit from its revenue and is indicated in the financial projections template by the net profit margin ratio.
Net profit margin ratio = Net income / Revenue
The ratio is an indicator of how well a business can control its costs in relation to its revenue. The higher the net profit margin ratio the more profit it earns from its revenue. A negative ratio indicates the business makes an loss.
When completed the financial projections should show a positive net profit margin ratio which increases year on year and is consistent with the industry in which the business operates.
Efficiency is a term used to indicate the ability of the business to perform effectively and utilize its assets to generate revenue (which in turn generates profit).
The financial projection template indicates efficiency using the ratio of revenue to assets, sometimes referred to as the asset turnover ratio.
Asset turnover ratio = Revenue / Assets
The higher the asset turnover ratio the more efficient the business is at generating revenue from its asset base.
Note: From the accounting equation we have Assets = Debt (Liabilities) + Equity and so the ratio also measures how efficient the business is at generating revenue from the total debt and equity funding used in the business.
The calculation and use of the ratio is more fully discussed in our asset turnover ratio tutorial.
Leverage refers to the extent to which a business relies on liabilities including debt finance to fund its operations.
The financial projection template indicates leverage using the ratio of liabilities to assets, sometimes referred to as the debt ratio, debt to assets ratio or liabilities to assets ratio.
Debt ratio = Liabilities / Assets
The higher the ratio, the higher the level of liabilities and the greater the liabilities relative to assets in the business.
If the debt ratio is equal to 1, the liabilities are equal to the assets. The assets are funded entirely by liabilities, and the business is said to be highly leveraged.
If the debt ratio is 0, the liabilities are also equal to 0. None of the assets are funded by liabilities and must therefore all be funded by equity.
A debt ratio of 50% is a reasonable level, and indicates that the assets are 50% funded by liabilities and 50% funded by equity.
The calculation and use of the ratio is more fully discussed in our debt ratio tutorial.
Liquidity is a measure of whether a business can utilize its current assets (cash, accounts receivable, and inventories) to pay its current liabilities (accounts payable and other) as and when they fall due.
The financial projection template indicates liquidity using the ratio of current assets to current liabilities, referred to as the current ratio.
Current ratio = Current assets / Current liabilities
The higher the ratio, the higher the level of liquidity the business has. It varies from industry to industry, but generally the ratio should be at least equal to 1, and nearer 2 to allow a margin of safety.
The calculation and use of the ratio is more fully discussed in our current ratio tutorial.
Financial Projection Ratios Calculation Example
The four financial projection ratios have been chosen as they highlight different aspects of the business (profitability, efficiency, leverage, and liquidity). The ratios are are easy to calculate from any published set of financial statements, and to demonstrate this, we have set out below the calculation of the four ratios using the Apple Inc. balance sheet and income statement for 2013.
Profitability (Net income / Revenue) = 37,037 / 170,910 = 21.7% Efficiency (Revenue / Assets) = 170,910 / 207,000 = 0.83 Leverage (Assets / Equity) = 207,000 / 123,549 = 1.68 Liquidity (Current assets / Current liabilities) = 73,286 / 43,658 = 1.68
For simplicity, all of the financial projection ratios used in the template are based on values at the year end. If there are significant changes in the balance sheet items during the financial period, it is best to average the assets over the period using the beginning and ending balances.
It is important to monitor the four financial projections ratios produced by the template in order to ensure that they are in line with industry norms. Any variation in either the absolute value or the trend in the ratio should be analysed and explained before finalizing the business plan financial projections.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.