Financial Ratios: Your Business Health Checkup 🏥
Imagine you’re a doctor, but instead of checking people, you check businesses! Just like a doctor uses a thermometer, stethoscope, and blood tests to see if you’re healthy, financial ratios are the special tools we use to check if a business is healthy.
The Big Picture: What Are Financial Ratios?
Think of a lemonade stand. You want to know:
- Can I pay for more lemons tomorrow? (Liquidity)
- Do I have enough supplies to keep selling? (Working Capital)
- Will I still be here next year? (Solvency)
- Am I making money or losing it? (Profitability)
- Am I using my stuff wisely? (Activity)
- Would someone want to buy my stand? (Market)
Financial ratios answer ALL these questions with simple math!
1. Liquidity Ratios: Can I Pay My Bills TODAY?
The Story
Imagine you owe your friend $5 for lunch money. You check your piggy bank. Do you have $5 right now? That’s what liquidity means — having enough money RIGHT NOW to pay what you owe.
The Main Ratios
Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities
What it means: For every $1 you owe soon, how many dollars do you have?
Example:
- Your lemonade stand has $100 in cash and supplies
- You owe $50 to the lemon farmer
- Current Ratio = $100 ÷ $50 = 2.0
- You have $2 for every $1 you owe — Great!
Good number: Above 1.0 (ideally 1.5 to 2.0)
Quick Ratio (Acid Test)
Quick Ratio = (Cash + Receivables) ÷ Current Liabilities
What it means: Same as current ratio, but we ONLY count money or things that turn into money super fast. No inventory (because selling stuff takes time).
Example:
- Cash: $60
- Money friends owe you: $20
- You owe: $50
- Quick Ratio = ($60 + $20) ÷ $50 = 1.6
Good number: Above 1.0
Why It Matters
If your liquidity ratios are low, you might not be able to pay your bills. That’s like not having lunch money when you’re hungry!
2. Working Capital: Your Safety Cushion
The Story
Working capital is like the extra snacks in your backpack. You might not need them right now, but they’re there just in case!
The Formula
Working Capital = Current Assets - Current Liabilities
Example:
- You have $100 in current assets
- You owe $50 in current liabilities
- Working Capital = $100 - $50 = $50
This $50 is your cushion! It’s extra money to:
- Buy more lemons when they’re on sale
- Handle surprises (like your pitcher breaking)
- Keep running even on slow days
The Working Capital Ratio
Working Capital Ratio = Current Assets ÷ Current Liabilities
This is actually the same as the Current Ratio! Just a different name.
Positive vs. Negative
| Situation | Meaning | Feeling |
|---|---|---|
| Positive Working Capital | Assets > Liabilities | 😊 Safe! |
| Zero Working Capital | Assets = Liabilities | 😐 Risky |
| Negative Working Capital | Assets < Liabilities | 😰 Danger! |
3. Solvency Ratios: Will I Survive Long-Term?
The Story
Solvency is about the BIG picture. Liquidity asks “Can I pay today?” but solvency asks “Can I pay for the WHOLE year and beyond?”
It’s like asking: “Do I have enough savings to handle ALL my expenses, not just today’s lunch?”
The Main Ratios
Debt-to-Equity Ratio
Debt-to-Equity = Total Debt ÷ Total Equity
What it means: For every dollar YOU put in, how much did you BORROW?
Example:
- You borrowed $200 to start your stand
- Your own money invested: $100
- Debt-to-Equity = $200 ÷ $100 = 2.0
- You borrowed twice as much as you invested
Good number: Lower is safer (under 2.0 for most businesses)
Debt Ratio
Debt Ratio = Total Liabilities ÷ Total Assets
What it means: What percentage of everything you own was paid for with borrowed money?
Example:
- Total stuff you own: $300
- Total borrowed: $200
- Debt Ratio = $200 ÷ $300 = 0.67 or 67%
- 67% of your stuff was bought with borrowed money
Interest Coverage Ratio
Interest Coverage = Operating Income ÷ Interest Expense
What it means: Can you afford to pay the interest on your loans?
Example:
- Your profit before interest: $1,000
- Interest you owe: $200
- Interest Coverage = $1,000 ÷ $200 = 5.0
- You can pay your interest 5 times over!
Good number: Above 2.0
4. Profitability Ratios: Am I Making Money?
The Story
This is the fun part! After all your hard work, are you actually making money? It’s like counting your allowance at the end of the week to see if you saved anything.
The Main Ratios
Gross Profit Margin
Gross Profit Margin = (Revenue - Cost of Goods) ÷ Revenue × 100
What it means: After paying for lemons and cups, what percentage is left?
Example:
- You sold $100 of lemonade
- Lemons and cups cost $40
- Gross Profit = $100 - $40 = $60
- Gross Margin = $60 ÷ $100 = 60%
Net Profit Margin
Net Profit Margin = Net Income ÷ Revenue × 100
What it means: After paying for EVERYTHING, what percentage is left?
Example:
- Revenue: $100
- ALL expenses: $75
- Net Income: $25
- Net Margin = $25 ÷ $100 = 25%
You keep 25 cents from every dollar!
Return on Assets (ROA)
ROA = Net Income ÷ Total Assets × 100
What it means: How well are you using your stuff to make money?
Example:
- Net Income: $500
- All your equipment and cash: $2,500
- ROA = $500 ÷ $2,500 = 20%
Your stuff earns 20 cents per dollar invested!
Return on Equity (ROE)
ROE = Net Income ÷ Shareholders' Equity × 100
What it means: How well is the OWNER’S money working?
Example:
- Net Income: $500
- Owner’s Investment: $1,000
- ROE = $500 ÷ $1,000 = 50%
The owner earned 50% on their investment!
5. Activity Ratios: Am I Using My Stuff Wisely?
The Story
Imagine you have 100 toys but only play with 5. That’s wasteful! Activity ratios check if you’re using your stuff efficiently.
The Main Ratios
Inventory Turnover
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
What it means: How many times did you sell and replace your stuff?
Example:
- Cost of lemonade sold: $1,000
- Average inventory: $200
- Turnover = $1,000 ÷ $200 = 5 times
You refreshed your inventory 5 times this year!
Higher is better — it means you’re selling fast!
Accounts Receivable Turnover
AR Turnover = Net Credit Sales ÷ Average Accounts Receivable
What it means: How fast do people pay you back?
Example:
- Credit sales: $10,000
- Average money owed to you: $1,000
- AR Turnover = $10,000 ÷ $1,000 = 10 times
People pay you back 10 times per year (about every 36 days)!
Asset Turnover
Asset Turnover = Revenue ÷ Total Assets
What it means: How hard is your stuff working to make sales?
Example:
- Revenue: $5,000
- Total Assets: $2,500
- Asset Turnover = $5,000 ÷ $2,500 = 2.0
Every dollar of assets creates $2 in sales!
6. Market Ratios: Would Someone Buy My Business?
The Story
If you wanted to sell your lemonade stand, how would buyers decide if it’s worth the price? Market ratios help investors decide if a company’s stock is a good deal.
The Main Ratios
Earnings Per Share (EPS)
EPS = Net Income ÷ Number of Shares
What it means: How much profit does each piece of ownership get?
Example:
- Company earned: $100,000
- Total shares: 10,000
- EPS = $100,000 ÷ 10,000 = $10 per share
Each share earned $10 this year!
Price-to-Earnings Ratio (P/E)
P/E Ratio = Stock Price ÷ Earnings Per Share
What it means: How many years of earnings would it take to pay for the stock?
Example:
- Stock price: $50
- EPS: $10
- P/E = $50 ÷ $10 = 5
It would take 5 years of earnings to pay for one share.
Lower P/E = possibly a bargain Higher P/E = investors expect big growth
Price-to-Book Ratio (P/B)
P/B Ratio = Stock Price ÷ Book Value Per Share
What it means: Are you paying more than the company is worth on paper?
Example:
- Stock price: $50
- Book value per share: $25
- P/B = $50 ÷ $25 = 2.0
You’re paying twice the book value (investors expect growth!)
Dividend Yield
Dividend Yield = Annual Dividends Per Share ÷ Stock Price × 100
What it means: What percentage do you earn just from dividends?
Example:
- Dividend per share: $2
- Stock price: $50
- Yield = $2 ÷ $50 = 4%
You earn 4% just from dividends!
The Complete Picture
graph LR A["Financial Health Check"] --> B["Liquidity"] A --> C["Working Capital"] A --> D["Solvency"] A --> E["Profitability"] A --> F["Activity"] A --> G["Market"] B --> B1["Current Ratio"] B --> B2["Quick Ratio"] C --> C1["Working Capital Amount"] D --> D1["Debt-to-Equity"] D --> D2["Debt Ratio"] D --> D3["Interest Coverage"] E --> E1["Gross Margin"] E --> E2["Net Margin"] E --> E3["ROA"] E --> E4["ROE"] F --> F1["Inventory Turnover"] F --> F2["AR Turnover"] F --> F3["Asset Turnover"] G --> G1["EPS"] G --> G2["P/E Ratio"] G --> G3["P/B Ratio"] G --> G4["Dividend Yield"]
Quick Memory Tricks
| Category | Question It Answers | Key Ratios |
|---|---|---|
| Liquidity | Can I pay bills NOW? | Current, Quick |
| Working Capital | Do I have a cushion? | Assets - Liabilities |
| Solvency | Will I survive long-term? | Debt-to-Equity, Debt Ratio |
| Profitability | Am I making money? | Margins, ROA, ROE |
| Activity | Am I efficient? | Turnovers |
| Market | Is the stock a good deal? | P/E, EPS, Dividend Yield |
You Did It!
Now you can check any business’s health like a pro! Remember:
- Liquidity = Today’s cash
- Working Capital = Your safety net
- Solvency = Long-term survival
- Profitability = Making money
- Activity = Using stuff wisely
- Market = What investors think
You’re now a financial detective! 🔍💰