Key Takeaways:
- Chicago organizations heavily rely on financial ratios to gauge performance, enabling benchmarking, trend analysis, and data-driven decision-making.
- Key financial ratios include the current ratio (measuring short-term debt-paying ability), quick ratio (assessing short-term liquidity), gross profit margin ratio (evaluating profitability after direct costs), and debt-to-equity ratio (measuring financial risk).
- KRD CPAs provide insights on essential ratios such as current, quick, gross profit margin, and debt-to-equity ratios, offering guidance for clients, prospects, and others seeking to assess financial health and make informed decisions.
Many Chicago organizations rely on financial ratios to understand and evaluate performance. These ratios are often used for benchmarking to gain insight into performance, understand trends, and make data-driven decisions. The ratios provide the opportunity to evaluate a company’s performance and compare it against prior periods or against industry competitors. A company can conduct ratio analysis using the standard financial and accounting reports for current and past periods.
While there are dozens of types of ratios, the most common include liquidity, activity, debt, profitability, and market ratios. Each offers insight into a specific aspect of operations and is relied upon for various purposes. However, there are several important ratios that should regularly be evaluated, including the current, quick, debt-to-equity, and gross profit margin ratios. To help clients, prospects, and others, KRD CPAs have provided a summary of the essential information below.
Key Financial Ratios
- Current Ratio – This is a liquidity ratio that measures the ability to pay short-term debt obligations including those due within one year. Also known as the working capital ratio, it is calculated by dividing current assets into current liabilities. An asset is considered current if it can be turned into cash within one year or less, while current liabilities are those that must be paid within the same timeframe. Ideally, the higher the current ratio the better for a business. However, it is generally considered acceptable when the current ratio is between 1.2 to 2. This means the organization has two times more current assets than liabilities to cover debts.
- Quick Ratio – This ratio measures a company’s short-term liquidity against short-term obligations. It attempts to understand whether a company has enough cash to cover current liabilities and other impending debts. It is calculated by dividing current assets into current liabilities. An excellent quick ratio score is anything above a 1 or 1:1 as this means the company has the same amount of liquid assets as current liabilities. A number of 5 indicates a business has enough liquid assets to pay debt five times over.
- Gross Profit Margin Ratio – This ratio measures profitability after paying the direct cost of doing business such as labor, materials, or production costs. It is one of the most important profitability ratios because, without a high enough gross profit, a business cannot survive for long. It is calculated by subtracting costs of goods sold (COGS) from net sales (gross revenue minus returns, allowances, and discounts). The resulting number is then divided by net revenue and multiplied by 100%. Generally, a good gross profit margin would be between 50% -70%, but it can vary significantly by industry.
- Debt to Equity – This ratio measures how much debt a company carries compared to its assets. This ratio measures financial risk and is routinely evaluated by financial institutions before issuing loans to a company. It is calculated by dividing total liabilities by shareholder equity. An ideal debt-to-equity ratio is between 2 to 2.5. This means that for every dollar invested in the company, about 66 cents comes from debt and equity. When the ratio is meager, it may indicate that the company is mature and has accumulated a lot of money.
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Financial ratios are an excellent way to evaluate performance and benchmark against past performance or other industry companies. There are not only general business ratios, but more specific ones used to help evaluate industry performance. If you have questions about the information outlined above or need assistance with a tax or accounting need, KRD CPAs can help. For additional information call 847-240-1040 or click here to contact us. We look forward to speaking with you soon.
