Financial ratios are invaluable tools, as they help you obtain a clear picture of a company’s financial performance. Understanding a company's financial health is key to successful business management and growth. With this goal in mind, ratios provide valuable insights into a company's financial situation, from liquidity and solvency to profitability and leverage.

In this article, our corporate accounting experts present 4 types of financial ratios that will help SMEs to better understand how well their business is performing.

## Financial ratio definition

Financial ratios are key indicators for assessing a company's performance and financial health. In essence, a financial ratio is a coefficient or percentage that is calculated by relating two relevant financial elements in a company's accounts.

These ratios are fundamental to decision-making, as they provide an overview of a company’s financial situation, make it possible to evaluate results according to industry standards and past performance, and help forecast future trends. Managers, investors and analysts use ratios to assess a company's profitability, solvency, efficiency and financial stability.

### Types of financial ratios

**Liquidity ratios**: These ratios measure a company's ability to cover its short-term debts with its short-term assets. They include the current ratio and the quick ratio.**Solvency ratios**: These ratios assess a company's ability to meet its long-term obligations and sustain continued growth. They include the debt-to-equity ratio and the interest coverage ratio.**Profitability ratios**: These indicate a company's ability to generate profits in relation to its sales, total assets and shareholders' equity. Common examples are net profit margin and return on equity.**Leverage ratios**: These ratios determine the degree to which a company uses debt to finance its operations. They provide an understanding of the extent to which the company is "leveraged" and include ratios such as debt-to-equity and total debt.

## 1. Liquidity ratios

Liquidity ratios help evaluate your SME's ability to repay its debts and meet financial commitments. Creditors will look at these ratios to assess your company's financial situation quickly and efficiently before choosing to invest.

### Current ratio

The first ratio in this category is the current ratio, or working capital ratio. This ratio measures a company's ability to meet its short-term commitments.

To calculate your current ratio, divide your current assets (inventory, cash and accounts receivable) by your current liabilities (line of credit balance, long-term debt or accounts payable). The higher your SMB's current ratio, the more solvent your business is. It is therefore a good indicator of short-term performance.

#### Example of current ratio

Suppose an SME has the following financial data:

Current (short-term) assets :

**Stocks**: 50 000 $**Cash**: 20 000 $**Customer accounts**: 30 000 $**Total current assets**: 100 000 $ (50 000 $ + 20 000 $ + 30 000 $)

**Current (short-term) liabilities :**

**Balance on lines of credit**: 25 000 $**Short-term debt**: 10 000 $**Accounts payable**: 15 000 $**Total current liabilities**: 50 000 $ (25 000 $ + 10 000 $ + 15 000 $)

**The current ratio would therefore be calculated as follows:**

**Current ratio**= Current assets / Current liabilities**Current ratio**= 100 000 $ / 50 000 $**Current ratio**= 2

In this example, the current ratio is 2, meaning that for every dollar of short-term liabilities, the company has two dollars of short-term assets.

### Quick ratio

The quick ratio measures your company's ability to quickly access cash to meet immediate commitments. It is also often referred to as the cash flow ratio, because it indicates the company's financial readiness to meet short-term deadlines.

This ratio is calculated by dividing current assets (excluding inventory) by current liabilities. Depending on your industry, a ratio greater than or equal to 1.0 is considered acceptable. On the other hand, a ratio of less than 1.0 may indicate that your company is in financial trouble, since it cannot access cash quickly.

#### Example of a quick ratio

Suppose an SME has the following financial data:

**Current assets (not including stocks)**:

**Cash**: 15 000 $**Customer accounts**: 25 000 $**Total current assets (not including stocks)**: 40 000 $ (15 000 $ + 25 000 $)

**Current liabilities:**

**Line of credit**: 20 000 $**Accounts payable**: 10 000 $**Total current liabilities**: 30 000 $ (20 000 $ + 10 000 $)

**The quick ratio would therefore be:**

**Quick ratio**= Current assets (not including stocks) / Current liabilities**Quick ratio**= 40 000 $ / 30 000 $**Quick ratio**= 1.33

In this example, the quick ratio is 1.33, meaning that the company has $1.33 of liquid assets for every dollar of current liabilities.

## 2. Solvency ratios

Solvency ratios play a vital role in assessing a company's ability to meet its long-term financial commitments. Unlike liquidity ratios, which focus on the short term, solvency ratios examine financial viability and stability over a longer period. They are essential for assessing whether a company is structurally sound, able to support its debts and finance future growth. Long-term lenders and investors will scrutinize these ratios, as they reveal a company's ability to generate sufficient cash flow to cover its debt obligations over a long period, while maintaining its operations.

### Debt-to-equity (D/E) ratio

This ratio is calculated by dividing total liabilities by total assets. It measures the percentage of a company's assets financed by debt. A high debt-to-equity ratio may indicate higher financial risk, as the company relies more heavily on debt to finance its activities. A lower ratio is generally preferable, indicating a greater proportion of assets financed by equity.

#### Example of debt-to-equity ratio:

Suppose an SME has the following financial data:

**Total assets:**

**Current assets**: 100 000 $**Long-term assets**: 200 000 $**Total assets**: 300 000 $ (100 000 $ + 200 000 $)

**Total liabilities:**

**Short-term liabilities**: 50 000 $**Long-term liabilities**: 100 000 $**Total liabilities**: 150 000 $ (50 000 $ + 100 000 $)

**The debt-to-equity ratio would therefore be:**

**Debt-to-equity ratio**= Total assets / Total liabilities**Debt-to-equity ratio**= 150 000 $ / 300 000 $**Debt-to-equity ratio**= 0.5 or 50 %

In this example, the gearing ratio is 0.5, or 50%, meaning that 50% of the company's assets are financed by debt.

### Interest coverage ratio

This ratio measures a company's ability to pay interest on its debt. It is calculated by dividing earnings before interest and taxes (EBIT) by interest expense. A high interest coverage ratio means that the company generates enough income to easily cover its interest, indicating good financial health. A low ratio can be a red flag, suggesting that the company may be struggling to manage its debts.

#### Example of interest coverage ratio

Let's imagine a company with the following financial data for a given year:

**Earnings before interest and taxes (EBIT)**: 200 000 $**Annual interest expense**: 40 000 $

**Let's calculate the interest coverage ratio:**

**Interest coverage ratio**= EBIT / Interest expense**Interest coverage ratio**= 200 000 $ / 40 000 $**Interest coverage ratio**= 5

In this example, the interest coverage ratio is 5, which means that the company generates five times more income (before interest and tax) than it has to pay in interest expense.

## 3. Profitability ratios to measure the financial viability of your business

Profitability ratios are some of the most important financial ratios. They are used to assess the development and viability of your SME based on your financial statements. Above all, using these ratios will allow you to compare your financial performance with that of other companies in your field of activity.

Here are two examples of profitability ratios.

### Net profit margin ratio

This ratio measures how much your company earns in relation to your sales. It is called the net profit margin because this financial ratio is calculated after taxes. This percentage is obtained by dividing your net profits by your net sales. If your ratio is higher than that of your competitors, it could mean that your company is financially healthier and capable of positioning itself for new opportunities.

#### Example of net profit margin ratio

Suppose a company has the following financial results for a given year:

**Net income (after tax)**: 60 000 $**Net sales**: 300 000 $

**Let's calculate the net profit margin ratio:**

**Net profit margin ratio**= Net income / Net sales**Net profit margin ratio**= 60 000 $ / 300 000 $**Net profit margin ratio**= 0.2 or 20 %

In this example, the net profit margin ratio is 20%, meaning that for every dollar of sales, the company makes a net profit of 20 cents.

### Return on total assets ratio

The return on total assets ratio is a percentage that measures the profitability of the total assets and capital invested in your business. Simply divide your net income by the value of total assets to obtain it. The result indicates whether the company's resources and assets are being properly utilized by management.

Not surprisingly, the higher this ratio, the more profitable and efficient your use of total assets. However, a caveat is that this number may be subject to industry-specific realities, such as a tendency for high asset utilization if you are a service company.

#### Example of return on assets ratio

Let's imagine a company with the following financial data for a given year:

**Net income after tax**: 80 000 $**Total assets**: 400 000 $

**Let's calculate the return on assets ratio:**

**Return on assets ratio**= Net income / Total assets**Return on assets ratio**= 80 000 $ / 400 000 $**Return on assets ratio**= 0.2 or 20 %

In this example, the return on assets ratio is 20%, meaning that the company generates 20 cents of profit for every dollar of assets.

## 4. Financial leverage ratios

Leverage ratios are financial ratios that show the long-term financial health of your company and its use of long-term borrowing. They are different from liquidity ratios.

There are several types of leverage ratios. Here are some examples.

### Debt ratio

As its name suggests, the debt ratio allows you to see how your assets are financed (by creditors, by you, etc.). This ratio is mainly used by banks (as it is for individuals) to measure your ability to repay your debts.

The ratio is calculated by dividing your total liabilities by your total assets. A low ratio is usually a good sign for banks. It indicates that your assets are greater than your liabilities.

#### Example of debt ratio

Suppose a company has the following financial data:

**Total assets**: 500 000 $**Total liabilities**: 200 000 $

**Let's calculate the total debt-to-asset ratio:**

**Debt ratio**= Total liabilities / Total assets**Debt ratio**= 200 000 $ / 500 000 $**Total debt ratio**= 0.4 or 40 %

In this example, the total debt ratio is 0.4, or 40%, which means that 40% of the company's assets are financed by debt.

### Leverage ratio

The leverage ratio relates the amount of total assets financed by the company to each dollar invested by shareholders. It is calculated by dividing total assets by equity.

Also known as return on equity, it is used to measure the profitability of your company in relation to the investment of your creditors.

#### Example of leverage ratio

Let's take the example of a company with the following financial data:

**Total assets**: 600 000 $**Shareholders' equity**: 300 000 $

**Calculating the leverage ratio:**

**Leverage ratio**= Total assets / Shareholders' equity**Leverage ratio**= 600 000 $ / 300 000 $**Leverage ratio**= 2

In this example, the leverage ratio is 2, meaning that for every dollar of equity invested by shareholders, the company uses two dollars of assets.

### Debt-service coverage ratio (DCSR)

The debt service coverage ratio indicates the EBITDA (earnings before interest, taxes, depreciation and amortization) a company generates for each dollar of interest and principal paid.

A higher ratio is preferable, as it indicates that your company can easily repay its debt.

The debt service ratio is widely used by banks and investors to understand a company's Level of Indebtedness and its prospects.

#### Example of debt-service coverage ratio

Let's take the example of a company with the following financial data for a given year:

**EBIT**: 150 000 $**Total debt service payments (interest and principal repayments)**: 50 000 $

**Let's calculate the debt-service coverage ratio:**

**Debt-service coverage ratio**= EBIT / Total debt service payments**Debt-service coverage ratio**= 150 000 $ / 50 000 $**Debt-service coverage ratio**= 3

In this example, the debt service ratio is 3. This means that the company generates three times the amount needed to cover its debt payments.

## Pitfalls to avoid

When using financial ratios, avoid making the following common mistakes:

**Over-interpretation of a single ratio**: Relying on a single ratio to make a decision can lead to erroneous conclusions. It's important to consider a set of ratios to get the full picture.**Ignoring the company's context**: Ratios should always be analyzed in the light of the company's specific sector, size and stage of development.**Neglecting external factors**: Always consider elements such as general economic conditions, regulatory changes and market developments, as these can influence ratios.**Lack of consistency**: Consistent and comparable methods must be used from one period to the next to ensure accurate analysis.

## T2inc can help you understand financial ratios

In short, calculating the liquidity, profitability and leverage ratios allows you to have a better overview of the financial performance of your small or medium-sized business. This will make it easier for you to set goals for the growth and development of your company.

Do you need more advice on financial management, taxation and business accounting? At T2inc, our qualified tax accountants can help you set up a strategic plan for your SME.

Contact us today to learn more about our tax and accounting services designed for businesses! In addition, our online corporate tax solution allows you to file your T2 and Co17 reports with confidence and the assistance of real professionals.