When developing financial projections for your business plan it is useful to monitor the financial ratios produced so that they can be compared with other available data. By making the comparisons it is possible to see whether your financial projections are in line with industry, competitor, and if available, historical data. If the financial ratio comparisons reveal unexplained variations then the assumptions in the plan need to be improved and fine tuned to bring the projections in line with expectations.
What are Financial Ratios
Financial ratios are a relative measure of two or more values taken from the financial statements of a business and can be expressed as a decimal value such as 0.45 or as a percentage e.g. 45%. Financial ratios are used to analyse business trends and measure performance of both the business and the management.
One financial ratio viewed in isolation will not tell you a great deal about a business. The key to using financial ratios is to chose the ratios which are most critical to your business, decide on the formula to use, which should be the same as that used by comparable businesses in your industry, and consistently monitor the ratio over time relative to other ratios you have calculated.
Key Financial Ratios
Our financial projections template includes many standard financial ratios which can be used to highlight trends in the projections and to make comparisons with historical and industry data.
Financial ratios can be split into six main categories
- Profitability Ratios
- Liquidity Ratios
- Efficiency ratios
- Leverage Ratios
- Activity ratios
- Investor ratios
Profitability Financial Ratios
The profitability ratios are used to measure the ability of a business and its management to generate profit and the following financial ratios are included and calculated for you in the financial projections template:
- Gross margin percentage
- Operating expenses ratio
- Return on sales
- Net profit ratio
- Return on capital employed (ROCE)
Profitability Ratio Example – Gross margin Percentage
The gross margin percentage is the ratio of the gross margin to the revenue and is a measure of the true income a business generates from its revenue.
| Revenue | 2,000 |
| Cost of sales | 900 |
| Gross margin | 1,100 |
| Operating expenses | 600 |
| Depreciation | 200 |
| Operating income | 300 |
| Finance costs | 100 |
| Income before tax | 200 |
| Income tax expense | 60 |
| Net income | 140 |
The numbers used in the calculation of the gross margin percentage are highlighted in the income statement shown above.
Gross margin percentage = Gross margin / Revenue Gross margin percentage = 1,100 / 2,000 Gross margin percentage = 55%
Efficiency Financial Ratios
Efficiency ratios are used to measure the ability of a business to control and manage its assets to produce the maximum amount of revenue and profit from them. The following financial ratios are included and calculated for you in the financial projections template:
- Asset turnover ratio
- Fixed asset turnover ratio
- Working capital turnover ratio
Efficiency Ratio Example – Asset Turnover Ratio
The asset turnover ratio shows the revenue generated by the assets of your business. It is a measure of the efficiency with which the business uses its resources. It is calculated by dividing revenue by assets
| Income Statement | Balance Sheet | |||
| Revenue | 2,000 | Cash | 50 | |
| Cost of sales | 900 | Accounts receivable | 280 | |
| Gross margin | 1,100 | Inventory | 20 | |
| Operating expenses | 600 | Current assets | 350 | |
| Depreciation | 200 | Long term assets | 450 | |
| Operating income | 300 | Total assets | 800 | |
| Finance costs | 100 | Accounts payable | 150 | |
| Income before tax | 200 | Other liabilities | 85 | |
| Income tax expense | 60 | Current liabilities | 235 | |
| Net income | 140 | Long-term debt | 145 | |
| Total liabilities | 380 | |||
| Capital | 150 | |||
| Retained earnings | 270 | |||
| Total equity | 420 | |||
| Total liabilities and equity | 800 | |||
The numbers used in the calculation of the gross margin percentage are highlighted in the income statement and balance sheet shown above.
Asset turnover ratio = Revenue / Assets Asset turnover ratio = 2,000 / 800 Asset turnover ratio = 2.50
Liquidity Financial Ratios
A liquidity ratio is used to measure the ability of a business to generate cash to meet its short term liabilities and debts. The following financial ratios are included and calculated for you in the financial projections template:
- Current ratio
- Quick ratio
Liquidity Ratio Example – Current Ratio
The current ratio measures the liquidity of a business and its ability to meet its short term liabilities and debts. It is calculated by dividing current assets by current liabilities.
| Cash | 50 |
| Accounts receivable | 280 |
| Inventory | 20 |
| Current assets | 350 |
| Long term assets | 450 |
| Total assets | 800 |
| Accounts payable | 150 |
| Other liabilities | 85 |
| Current liabilities | 235 |
| Long-term debt | 145 |
| Total liabilities | 380 |
| Capital | 150 |
| Retained earnings | 270 |
| Total equity | 420 |
| Total liabilities and equity | 800 |
The numbers used in the calculation of the current ratio are highlighted in the balance sheet shown above.
Current ratio = Current Assets / Current Liabilities Current ratio = 350 / 235 Current ratio = 1.49
Leverage Financial Ratios
A leverage ratio is used to show the capital structure of the business and in particular the level of debt in relation to owners equity. A business with a high level of debt is considered to be more risky but will give greater returns to the owners provided cash and profit are managed correctly. The following financial ratios are included and calculated for you in the financial projections template:
- Gearing ratio
- Debt equity ratio
- Times interest earned
Leverage Ratio Example – Debt Equity Ratio
The debt equity ratio is the ratio of how much a business owes (debt) compared to how much the owners have invested (equity). It is calculated by dividing debt by owners equity.
| Cash | 50 |
| Accounts receivable | 280 |
| Inventory | 20 |
| Current assets | 350 |
| Long term assets | 450 |
| Total assets | 800 |
| Accounts payable | 150 |
| Other liabilities | 85 |
| Current liabilities | 235 |
| Long-term debt | 145 |
| Total liabilities | 380 |
| Capital | 150 |
| Retained earnings | 270 |
| Total equity | 420 |
| Total liabilities and equity | 800 |
The numbers used in the calculation of the debt equity ratio are highlighted in the balance sheet shown above.
Debt equity ratio = Debt / Equity Debt equity ratio = 145 / 420 Debt equity ratio = 34.5%
Note in this example there is only long term debt shown in the balance sheet, in practice all forms of debt should be included in the calculation.
Leverage ratios assess a businesses ability to pay off long-term debt including obligations to creditors, bondholders, and banks and for this reason are sometimes referred to as solvency ratios.
Activity Financial Ratios
Activity ratios are used to measure the ability of a business to convert different balance sheet accounts such as inventory, accounts receivable, and accounts payable into cash or sales. The following financial ratios are included and calculated for you in the financial projections template:
- Accounts receivable days ratio
- Accounts payable days ratio
- Inventory days
Activity Ratio Example – Accounts Receivable Days Ratio
The accounts receivable days ratio shows the average number of days your customers are taking to pay you. It is calculated by dividing accounts receivable by average daily sales.
| Income Statement | Balance Sheet | |||
| Revenue | 2,000 | Cash | 50 | |
| Cost of sales | 900 | Accounts receivable | 280 | |
| Gross margin | 1,100 | Inventory | 20 | |
| Operating expenses | 600 | Current assets | 350 | |
| Depreciation | 200 | Long term assets | 450 | |
| Operating income | 300 | Total assets | 800 | |
| Finance costs | 100 | Accounts payable | 150 | |
| Income before tax | 10 | Other liabilities | 85 | |
| Income tax expense | 60 | Current liabilities | 235 | |
| Net income | 140 | Long-term debt | 145 | |
| Total liabilities | 380 | |||
| Capital | 150 | |||
| Retained earnings | 270 | |||
| Total equity | 420 | |||
| Total liabilities and equity | 800 | |||
The numbers used in the calculation of the gross margin percentage are highlighted in the income statement and balance sheet shown above.
Accounts receivable days ratio = Accounts Receivable / (Revenue/365) Accounts receivable days ratio = 280/ (2,000/365) Accounts receivable days ratio = 51.1 days
Note: In this example the closing balance sheet is used to obtain the value of accounts receivable. If available, it is good practice to use values from both the opening and closing balance sheets to give an average value fro accounts receivable.
Investor Financial Ratios Analysis
Investor ratios are used to measure the ability of a business to earn an adequate return for the owners of the business. The owners have money tied up in the business and need a return commensurate with the risk involved. The following financial ratios are included and calculated for you in the financial projections template:
- Return on Equity (ROE)
- Dividend cover
Investor Ratio Example – Return on Equity (ROE)
The return on equity measures the percentage rate of return the owner of a business gets on their investment. It is calculated by dividing the net income by the owners equity.
| Income Statement | Balance Sheet | |||
| Revenue | 2,000 | Cash | 50 | |
| Cost of sales | 900 | Accounts receivable | 280 | |
| Gross margin | 1,100 | Inventory | 20 | |
| Operating expenses | 600 | Current assets | 350 | |
| Depreciation | 200 | Long term assets | 450 | |
| Operating income | 300 | Total assets | 800 | |
| Finance costs | 100 | Accounts payable | 150 | |
| Income before tax | 10 | Other liabilities | 85 | |
| Income tax expense | 60 | Current liabilities | 235 | |
| Net income | 140 | Long-term debt | 145 | |
| Total liabilities | 380 | |||
| Capital | 150 | |||
| Retained earnings | 270 | |||
| Total equity | 420 | |||
| Total liabilities and equity | 800 | |||
The numbers used in the calculation of the return on equity are highlighted in the income statement and balance sheet shown above.
Return on equity = Net income / Equity Return on equity = 140 / 420 Return on equity = 33.3%
Financial ratios are derived from information included in the income statements and balance sheets of the business plan financial projections. The ratios are used as indicators of the the financial health of the business and for comparing the performance of the business with other businesses in the same sector, and can be used to fine tune the financial projections.
When the financial projections have been prepared, equity investors, providers of debt finance, and many trade credit suppliers will use financial ratios analysis to assess the business to decide whether or not to invest, provide loan facilities or to extend credit to the business.
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 degree from Loughborough University.