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17.4 Compute and Interpret Financial Ratios

Types of Financial Ratios​

Four Main Categories:

  1. Liquidity Ratios: Ability to pay short-term obligations
  2. Solvency Ratios: Ability to meet long-term obligations
  3. Profitability Ratios: Ability to generate profits
  4. Efficiency Ratios: How efficiently assets are used

Liquidity Ratios​

Current Ratio: Current Ratio = Current Assets ÷ Current Liabilities

  • Measures short-term liquidity
  • Higher is generally better
  • Should be > 1.0
  • Typical range: 1.5 - 3.0

Example:

  • Current Assets: €100,000
  • Current Liabilities: €50,000
  • Current Ratio: €100,000 ÷ €50,000 = 2.0

Quick Ratio (Acid-Test): Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities

  • More conservative than current ratio
  • Excludes inventory (less liquid)
  • Should be > 1.0
  • Typical range: 1.0 - 2.0

Example:

  • Current Assets: €100,000
  • Inventory: €30,000
  • Current Liabilities: €50,000
  • Quick Ratio: (€100,000 - €30,000) ÷ €50,000 = 1.4

Solvency Ratios​

Debt-to-Equity Ratio: Debt-to-Equity = Total Debt ÷ Total Equity

  • Measures financial leverage
  • Lower is generally better (less risk)
  • Typical range: 0.5 - 2.0

Example:

  • Total Debt: €150,000
  • Total Equity: €100,000
  • Debt-to-Equity: €150,000 ÷ €100,000 = 1.5

Debt-to-Assets Ratio: Debt-to-Assets = Total Debt ÷ Total Assets

  • Measures percentage of assets financed by debt
  • Lower is generally better
  • Typical range: 0.3 - 0.7

Example:

  • Total Debt: €150,000
  • Total Assets: €250,000
  • Debt-to-Assets: €150,000 ÷ €250,000 = 0.6 (60%)

Profitability Ratios​

Gross Profit Margin: Gross Profit Margin = (Gross Profit ÷ Revenue) × 100

  • Measures profitability after cost of goods sold
  • Higher is better
  • Varies by industry

Example:

  • Revenue: €200,000
  • Cost of Goods Sold: €120,000
  • Gross Profit: €80,000
  • Gross Profit Margin: (€80,000 ÷ €200,000) × 100 = 40%

Net Profit Margin: Net Profit Margin = (Net Income ÷ Revenue) × 100

  • Measures overall profitability
  • Higher is better
  • Typical range: 5% - 20%

Example:

  • Net Income: €30,000
  • Revenue: €200,000
  • Net Profit Margin: (€30,000 ÷ €200,000) × 100 = 15%

Return on Assets (ROA): ROA = (Net Income ÷ Average Total Assets) × 100

  • Measures how efficiently assets generate profit
  • Higher is better
  • Typical range: 5% - 15%

Example:

  • Net Income: €30,000
  • Average Total Assets: €250,000
  • ROA: (€30,000 ÷ €250,000) × 100 = 12%

Return on Equity (ROE): ROE = (Net Income ÷ Average Equity) × 100

  • Measures return to owners
  • Higher is better
  • Typical range: 10% - 25%

Example:

  • Net Income: €30,000
  • Average Equity: €150,000
  • ROE: (€30,000 ÷ €150,000) × 100 = 20%

Efficiency Ratios​

Asset Turnover: Asset Turnover = Revenue ÷ Average Total Assets

  • Measures how efficiently assets generate revenue
  • Higher is better
  • Varies by industry

Example:

  • Revenue: €200,000
  • Average Total Assets: €250,000
  • Asset Turnover: €200,000 ÷ €250,000 = 0.8 times

Inventory Turnover: Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

  • Measures how quickly inventory is sold
  • Higher is generally better
  • Varies by industry

Example:

  • Cost of Goods Sold: €120,000
  • Average Inventory: €30,000
  • Inventory Turnover: €120,000 ÷ €30,000 = 4.0 times

Accounts Receivable Turnover: Receivables Turnover = Revenue ÷ Average Accounts Receivable

  • Measures how quickly receivables are collected
  • Higher is better

Example:

  • Revenue: €200,000
  • Average Accounts Receivable: €40,000
  • Receivables Turnover: €200,000 ÷ €40,000 = 5.0 times

Luxembourg Benchmarks​

Luxembourg SME Benchmarks:

  • Current Ratio: 1.5 - 2.5
  • Quick Ratio: 1.0 - 1.5
  • Debt-to-Equity: 0.5 - 1.5
  • Net Profit Margin: 5% - 15%
  • ROA: 5% - 12%
  • ROE: 10% - 20%

Industry Variations:

  • Retail: Lower margins, higher turnover
  • Services: Higher margins, lower turnover
  • Manufacturing: Varies by product

Luxembourg Compliance Note​

Financial ratios in Luxembourg:

  • Useful for analysis
  • Help evaluate performance
  • Support decision-making
  • Important for stakeholders
  • May be required for financing

Think It Through​

What do different types of ratios tell you about a business? How are they used together?