In this post we will move beyond the financial statements and consider briefly a few key financial ratios and why they are important. 

In previous posts, we’ve sometimes evoked ratios to try to contextualize and compare various numbers in the financial statements. And in general, this is exactly what ratios are good for. In this post, we’ll cover four different categories of financial ratios: 

  • Profitability, 
  • Leverage, 
  • Liquidity, and 
  • Efficiency.

Profitability Ratios

Simply put, these ratios evaluate a company’s ability to generate profits. There are dozens of profitability ratios, so below I highlight some of the most important ones. 

  • Gross Profit Margin
    • What it is: Gross Profit Margin (sometimes called simply gross margin) = gross profit/revenue
    • Why it matters: Gross margin shows the basic profitability of the product and/or service itself, before expenses or overhead. In other words, how much of the sale price is going to the materials and direct labor to produce that product or service. 
    • What to pay attention to: 
      • Higher is generally better- if you can’t cover your direct costs by selling your goods, you won’t be in business long.
      • Trend lines are important- negative trend can mean that the company may be discounting sales to increase volume or CoGs is increasing (or both). A negative trend can be an early warning indicator that a business may be in trouble.
  • Operating Profit Margin
    • What it is: Operating Profit Margin (Operating Margin) = operating profit (EBIT)/revenue
    • Why it matters: Operating margin is a more comprehensive measure of a company’s ability to generate a profit, as it uses operating profit, or EBIT (earnings before interest and taxes), as a numerator.  Here you are looking at how well the company is running itself.
    • What to pay attention to: a downward trend is a signal for management (and investors) to pay attention- costs are rising faster than sales.
  • Net Profit Margin
    • What it is: Net Profit Margin (Net Margin) = net profit/revenue
    • Why it matters: This ratio indicates how much of every sales dollar a company gets to keep after everything else has been paid for. Net profit is that proverbial bottom line, to this is the bottom line ratio. People sometimes refer to this as return on sales, or ROS.
    • What to pay attention to: This ratio is highly variable from industry to industry, so it is usually most meaningful to compare a company’s net margin across time and/or compare with players in the same industry. 
  • Return on Assets
    • What it is: Return on Assets (ROA) = net profit/total assets
    • Why it matters: ROA tells you what percentage of every dollar invested in the business was returned as profit. Stated otherwise, this ratio looks at how well a company is putting its assets (cash, facilities, inventory, etc) to work.
    • What to pay attention to: Unlike the other Profitability Ratios we’ve discussed so far, ROA can be too high. An ROA above the industry norm can indicate that a company is not investing in its asset base for the future, which can compromise long term prospects. ROA varies from industry to industry, so like with the other metrics, it’s best to compare amongst peers within an industry. There are more nefarious reasons ROA can be inflated (remember Enron?), but we’ll set those aside for now. 
  • Return of Equity
    • What it is: Return on Equity (ROE) = net profit/shareholders’ equity
    • Why it matters: While assets refer to what the company owns, equity refers to its net worth as determined by accounting rules. So ROE indicates the profit made for every dollar of equity invested in the company. 
    • What to pay attention to: From an investor’s perspective, s/he’ll generally be looking for a ROE above the going interest rates and asking the basic question: is this company even capable of generating a return that is worth the risk of investment? From a financial health perspective, this ratio is a bit tricky vis-a-vis comparison to other companies. A company’s ROE can be higher than a competitor because it has borrowed more money. Whether this position is good or bad will heavily depend on how smart the company has been in borrowing money. 
  • Other/Variations on a theme
    • Return on net assets (RONA), Return on total capital (ROTC), return on invested capital (ROIC), and return on capital employed (ROCE) are some other profitability ratios. They all answer the same basic question: did the company earn enough profit to justify the amount of ‘other people’s money’ it is using?
    • Generic formula: (net income before interest on debt and after tax)/(total equity + total interest bearing debt)
    • For the sake of brevity, we will not go into more depth here.

Leverage Ratios

These ratios evaluate how (and how extensively) a company uses debt. Fun fact: a financial analyst’s word for debt is leverage. So now you know. Leverage allows companies to make more money, but it also increases risk, because it introduces fixed costs that cannot easily be cut in the case of revenue reduction. 

  • Debt-to-Equity
    • What it is: Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
    • Why it matters: This ratio is often used by bankers to determine whether or not to offer a company a loan. 
    • What to pay attention to: Managers should care about this ratio, as raising cash through borrowing may be more difficult if this ratio is high, and expansion could require more equity investment. 
  • Interest Coverage
    • What it is: Interest Coverage = operating profit/annual interest charges
    • Why it matters: The ratio shows how easy it will be for a company to pay its interest. Bankers love it.
    • What to pay attention to: High ratio indicates that a company can reasonably take on more debt. If this ratio is close to 1, it indicates that most of the operative profit is used to pay interest- not good. In that situation, senior management will need to focus on paying off debt. 
    • Side note: there’s a sneaky construct called an operating lease, where companies lease equipment from an investor instead of buying it- then these lease payments show up as an expense on the income statement, but there is no asset and so no asset-related debt. 

Liquidity Ratios

Simply put, these ratios evaluate how well a company is able to pay its bills.

  • Current Ratio
    • What it is: Current ratio = current assets/current liabilities
    • Why it matters: It provides a measure of the company’s cash runway.
    • What to pay attention to: Too high or too low is a problem. Too high suggests the company is sitting on cash instead of investing it or returning it to shareholders. Too low (close to 1) means that the company is just barely able to cover its liabilities with the cash coming in. If this ratio is less than 1, then the company is going to run out of cash in the coming year and needs to generate more cash or attract more from investors.
  • Quick Ratio
    • What it is: Quick ratio = (current assets – inventory)/current liabilities
    • Why it matters: Also known as the ‘acid test,’ this ratio is a variation on the Current Ratio, but subtracting inventory, which is harder to convert to cash quickly. In other words, this ratio indicates a company’s ability to pay off short-term debt without needing to wait for inventory to sell.
    • What to pay attention to: If a particular business has a lot of their assets tied up in inventory (for instance, a reagent or consumable manufacturer), then lenders and vendors will be looking to see that this ratio is well about 1.

Finance for Scientists

A dollar sign with a pipette

More in this series

  1. Why am I writing about finance?
  2. How to learn the financial basics about a new (to you) business
  3. Every scientist’s dream: Understanding financial statements
  4. A first look at income statements: revenue, costs and profits
  5. What scientists need to understand about revenue and its recognition
  6. Income Statement Fun: What is included in the Cost of Sales and why you should care
  7. How expenses and depreciation can affect the profitability of your scientific work
  8. Profitability: the proverbial and literal bottom line
  9. Using the Balance Sheet to Understand a Company’s Financial Health
  10. Assets: tangible, intangible, and goodwill
  11. Decoding Financial Health with Liabilities & Equity from the Balance Sheet
  12. Navigating a company’s financial condition with the cash flow statement
  13. The Anatomy of a Cash Flow Statement: Operating, Investing, and Financing
  14. Budgeting 101: Using our newly acquired financial intelligence to make sense of the budgeting process
  15. Making Sense of the Numbers Through Financial Ratios
  16. Your Company’s Quarterly Earnings Call: How to Make Sense of It All
  17. The “Big Five” Numbers — What Investors Care About and Why
  18. Net Present Value: Making the Financial Case for Advancing Scientific Projects You Care About

Efficiency Ratios

These ratios evaluate how efficiently a company is managing its assets (and liabilities), which can have a direct impact on the company’s cash position.

  • Inventory Days 
    • What it is: Days in Inventory (DII) = average inventory/(COGS/Day)
    • Why it matters: This ratio measures the number of days inventory stays in the system. Inventory is somewhat ‘frozen cash,’ so the faster you turn it over, the better off you will be. It is used as a benchmark of operational efficiency.
    • What to pay attention to: What good looks like for this ratio will depend heavily on the industry, so best to benchmark to other players in your space.
  • Inventory Turnover
    • What it is: Inventory turns = 360/DII
    • Why it matters: If every item of inventory was processed at exactly the same rate, inventory turns would be the number of times per year you sold our your stock and had to replenish it. 
    • What to pay attention to: The higher the number of inventory turns, the tighter your management of inventory and the better your cash position. All else being equal, you want to increase this value. 
  • Days Sales Outstanding
    • What it is: DSO = ending accounts receivable/ (revenue/day)
    • Why it matters: This ratio is a measure of the time it takes to collect the cash from sales- how fast to customers pay their bills. Note that in the diagnostics space, this ratio may be high, as your payors are insurance companies, hospital systems, or the government, who aren’t necessarily known for their speediness.
    • What to pay attention to: Lower DSO means a stronger cash position. A high DSO can be a red flag, but it is important to contextualize this value based on the industry you are in.
  • Days Payable Outstanding
    • What it is: DPO = ending accounts payable/(COGS/day)
    • Why it matters: This ratio measures how long it takes a company to pay its own invoices. It’s the flipside of DSO.
    • What to pay attention to: A higher DPO means a stronger cash position, as you are holding onto your money for longer. However, this may not make your vendors very happy, so a balance must be struck. There are companies who have mastered the art of collecting payment from sales quickly, but paying vendors slowly, such that they have a very strong cash position. 
  • Property, Plant, and Equipment Turnover
    • What it is: PPE turnover = revenue/PPE
    • Why it matters: PPE turnover is a measure of how efficient a company is at generating revenue from fixed assets such as buildings and equipment. 
    • What to pay attention to: All other things being equal, the higher this ratio, the better the company is at putting its assets to work. However, companies may lease instead of buy equipment, which can make it challenging to compare across companies, as operating leases may not show up on the balance sheet (operating leases show up as an expense on the income statement).
  • Total Asset Turnover
    • What it is: Total asset turnover = revenue/total assets
    • Why it matters: Similar to PPE turnover, but looks at total assets, not just fixed assets. It measures the efficiency in the use of all assets.
    • What to pay attention to: This metric measures efficiency- tracking the trends here can help you measure your overall efficiency in using your assets.

In the next post, we will look at what ratios investors care about: the “Big Five” numbers. Please consider subscribing to be notified when it’s out!