Four Key Ratio Categories for Organizational Evaluation
To effectively evaluate an organization’s financial health, four general ratio categories are widely used:
1. Liquidity Ratios
Liquidity ratios are essential for assessing an organization’s ability to meet its short-term debt obligations
2. Operating Ratios
Operating ratios provide insight into how efficiently an organization manages its working capital and assets. The four commonly used operating ratios include:
Days’ Receivables: Measures the average time taken to collect receivables.
Days’ Inventory: Assesses the average time inventory is held before it is sold.
Days’ Payables: Evaluates the average time taken to pay off payables.
Sales to Assets Ratio: Analyzes how effectively assets are used to generate sales.
3. Financing Ratios
Financing ratios assess how an organization is funded, particularly the balance between debt and equity. The three key financing ratios are:
Interest Cover Ratio: Indicates how easily an organization can pay interest on its outstanding debt.
Debt to Equity Ratio: Compares the total debt to the shareholders’ equity.
Interest-Bearing Debt to Equity Ratio: Evaluates the proportion of interest-bearing debt relative to equity.
4. Profitability Ratios
Profitability ratios are crucial for determining an organization’s financial success. The four main profitability ratios include:
Gross Profit Margin: Indicates the percentage of revenue that exceeds the cost of goods sold.
EBIT Margin: Measures earnings before interest and taxes as a percentage of revenue.
Return on Assets (ROA): Assesses how efficiently assets generate profits.
Return on Equity (ROE): Evaluates the return generated on shareholders’ equity.
8.1.1.1. Current Ratio
The current ratio is a key financial metric that indicates how many times a company’s current assets exceed its current liabilities. A benchmark of 1.5 times or greater is generally considered safe, signaling strong liquidity or solvency. The higher the ratio, the more secure the organization is in meeting its short-term obligations. However, for organizations with a high proportion of cash sales, a lower benchmark may be more appropriate.
8.1.1.2. Quick Ratio
The quick ratio is another critical liquidity measure that evaluates an organization’s ability to pay off all current liabilities if they were due immediately. Unlike the current ratio, the quick ratio excludes inventory from the calculation, acknowledging that inventory might take longer to convert into cash. This makes the quick ratio a more stringent test of an entity’s short-term financial health.
Both the current and quick ratio benchmarks are typically based on medium-to-large commercial organizations. Small businesses, however, may often have ratios below these benchmarks, sometimes even less than 1:1.
Operating ratios are key indicators that assess how efficiently an organization manages its working capital and utilizes assets to generate sales. Below is a summary of the formulas and benchmarks for the four most commonly used operating ratios.
Financing Ratios
Financing ratios assess how an organization’s assets are funded, whether through debt, equity, or a combination of both. Typically, organizations use a mix of debt and equity to finance their assets. Some organizations are highly geared, meaning they depend heavily on debt financing, while others have minimal reliance on debt, indicating they are primarily equity-financed. There is no universally optimal debt-to-equity ratio; the appropriate level of gearing depends on the organization’s nature and the type of assets it holds. Below is a summary of the formulas and benchmarks for the three most common financing ratios.
Profitability Ratios
Profitability ratios evaluate an organization’s financial performance, specifically its ability to generate profit over a given period. These ratios are often compared over time, against other organizations, or with industry averages when available. For any for-profit organization, profitability is a key objective, crucial not only for shareholders but also for creditors and lenders. In the case of publicly listed companies, profitability can significantly influence the share price. Below is a summary of the formulas and benchmarks for the four most commonly used profitability ratios.
At Ardent Financial Solutions , we develop CFO dashboards with all the above Financial Ratios, that assists the organisations in making informed decisions in a timely manner.
