What are the 5 financial ratios?

The gross profit margin ratio compares the gross profit of your business to its total revenue to show how much profit your business is making after paying your cost of goods sold. This ratio shows the percentage margin between what you receive for your product or service and what it costs you in cost of sales. Your gross profit margin shows whether your sales are sufficient to cover your costs of goods sold.

It also allows you to compare your performance with other businesses, or over time, and is a good measure of how efficient your business is at converting products and services into revenue.

Formula: Gross profit margin (%) = (Gross profit ÷ Total revenue) x 100

Aim for: Your figure will depend on your industry or sector. For example, professional services might have 80% or higher, while manufacturing or construction industry might have between 45% and 60%.

Calculate gross profit margin

$$\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Total revenue}} \times 100$$

Brett's Bakery has a total sales revenue of $450,000. After subtracting the $300,000 cost of raw materials (e.g. flour, eggs, sugar) and wages directly involved in baking and selling the goods, the bakery has a gross profit of $150,000. Based on these sales and costs, they have a gross profit margin of 33.33%.

Whether you’re looking for ways to grow your business or simply interested in investing, financial ratios are a fundamental component of any analysis. Here’s a breakdown of important financial ratios, and why they’re so useful

1. Quick ratio

We’ll start off our list of the most important financial ratios with the quick ratio, also known as the acid test. This is one of the most frequently used types of financial ratios, giving a quick indicator of business liquidity. To calculate the quick ratio, you must subtract current inventory from current assets and then divide this by liabilities:

(Current Assets – Inventory) / Current Liabilities

This shows you how easily a business’s short-term debts will be covered by its existing liquid assets, or cash. If the quick ratio is greater than one, the business is in a good financial position. 

2. Debt to equity ratio

Another financial ratio to consider is debt to equity. This looks at whether or not a business is borrowing more than it can reasonably pay back using equity as a metric. To calculate debt to equity, you must divide total liabilities by shareholders equity:

Total Liabilities / Shareholders Equity

In other words, this ratio measures the degree to which the business’s operations are funded by debt. When this ratio is greater than one, the company holds more debt. If the value is below one, it indicates that the company holds less debt.

3. Working capital ratio

A third ratio pertaining to liabilities is the working capital ratio, also known as the current ratio. Like the quick ratio, this looks at how well a company can pay its existing debts. However, it considers all current assets rather than simply liquid assets, so you don’t need to subtract inventory from the equation. The working capital ratio looks like this when written as a formula:

Current Assets / Current Liabilities

The higher the working capital ratio, the easier it will be for a business to pay off debts using its current assets.

4. Price to earnings ratio

We’ve looked at a few of the key financial ratios related to liabilities, but what about those related to earnings? One of the top indicators for earnings potential is the price to earnings ratio, or P/E. This divides a company’s share price by its earnings per share.

Share Price / Earnings per Share

 In other words, it measures the amount an investor would pay for each dollar earned. This gives you a quick idea if a stock is under or overvalued. Because share prices vary by industry and market conditions, there isn’t a universal rule for what constitutes a “good” P/E. However, you can compare the company’s P/E to similar stock prices for comparison.

Along these same lines is the earnings per share or EPS, another quick ratio to use when assessing future earnings. Earnings per share measures the net income you’ll receive for each share of a company’s stock. To calculate EPS, you must divide net income by the number of outstanding common shares during the financial year.

Net Income / Outstanding Shares

This can potentially be a negative number, if the company has traded at a loss over the year. Usually, investors will look at EPS in combination with a number of other ratios like P/E to determine growth potential.

6. Return on equity ratio

Whether you’re investing your own money or interested in keeping shareholders happy, you’ll need to know the return on equity ratio. This is one of the most important financial ratios for calculating profit, looking at a company’s net earnings minus dividends and dividing this figure by shareholders equity.

(Earnings – Dividends) / Shareholders Equity

The result tells you about a company’s overall profitability, and can also be referred to as return on net worth. 

7. Profit margin

Speaking of profitability, the profit margin is one of the fundamental financial ratios to be aware of. This shows you how efficiently a company is managing its overall costs, or how well it converts revenue into profit. The formula for profit margin is:

Profit / Revenue

You can then multiply the result by 100 to convert it into a percentage. The higher the profit margin, the more efficient the company is in converting sales to profits.

While these are some of the most important financial ratios, you don’t necessarily need to consider all of them. You can pick and choose the most relevant of these key financial ratios to gain greater understanding of a company’s potential.

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Top 5 Financial Ratios

The most cost commonly and top five ratios used in the financial field include:

1. Debt-to-Equity Ratio

The debt-to-equity ratio, is a quantification of a firm’s financial leverage estimated by dividing the total liabilities by stockholders’ equity. This ratio indicates the proportion of equity and debt used by the company to finance its assets.

The formula used to compute this ratio is

Total Liabilities / Shareholders Equity

2. Current Ratio

The current ratio is a liquidity ratio which estimates the ability of a company to pay back short-term obligations. This ratio is also known as cash asset ratio, cash ratio, and liquidity ratio. A higher current ratio indicates the higher capability of a company to pay back its debts. The formula used for computing current ratio is:

Current Assets / Current Liabilities

3. Quick Ratio

The quick ratio, also referred as the “acid test ratio” or the “quick assets ratio”, this ratio is a gauge of the short term liquidity of a firm. The quick ratio is helpful in measuring a company’s short term debts with its most liquid assets.

The formula used for computing quick ratio is:

(Current Assets – Inventories)/ Current Liabilities

A higher quick ratio indicates the better position of a company.

4. Return on Equity (ROE)

The return on equity is the amount of net income returned as a percentage of shareholders equity. Moreover, the return on equity estimates the profitability of a corporation by revealing the amount of profit generated by a company with the money invested by the shareholders. Also, the return on equity ratio is expressed as a percentage and is computed as:

Net Income/Shareholder's Equity

The return on equity ratio is also referred as “return on net worth” (RONW).

5. Net Profit Margin

The net profit margin is a number which indicates the efficiency of a company at its cost control. A higher net profit margin shows more efficiency of the company at converting its revenue into actual profit. This ratio is a good way of making comparisons between companies in the same industry, for such companies are often subject to similar business conditions.

The formula for computing the Net Profit Margin is:

Net Profit / Net Sales 

We calculated average ratios based on SEC data for our readers – see industry benchmarking.

See also