Selecting and calculating financial ratios

What is a financial ratio? How do you calculate a financial ratio? How do you choose the most appropriate financial ratio for your situation? Find all the answers in this article.

Understanding financial ratios

A financial ratio provides clear and precise information on a company’s financial health. There are many financial ratios that provide a variety of data, which is often complementary.

These are expressed as ratios or percentages and may be presented in a financial analysis from the following perspective:

• to assist CFOs and business leaders in their decision-making, whether to secure capital or to increase investment;

• to persuade lenders (banks and other institutions) during the process of negotiating a loan to help grow the business;

• to reassure shareholders regarding the company’s performance in the short term (dividend payments) and in the medium term;

• to communicate with employees and staff in order to reassure them and involve them in the creation of value for the company.

It is particularly in the context of a company takeover or when comparing performance against the sector in which the company operates that financial ratios come into their own. Financial ratios therefore have practical significance; as a result, they generally focus on current rather than historical data.

Choosing the right financial ratios

Depending on the situation and the industry in question, the ratios to be used will vary; it is therefore essential to understand them fully in order to select the most appropriate ones.

To select the most relevant financial ratios, it is advisable to base your decision on:

• analysis of key performance indicators (KPIs);
• an analysis of the business environment (sector, competition and market);
• analysis of the content of the financial statements (balance sheet, profit and loss account, cash flow statement, etc.)

The purpose for which you are using financial ratios and the timeframe within which you wish to act are two further factors to consider when making your decision.

Ultimately, it all depends on the specific challenges your company faces. Liquidity, solvency, profitability, financial risk coverage… There are several ratios for each of these areas.

Calculate a financial ratio

Profitability ratios

Profitability ratios are designed to assess a company’s current performance.
For this reason, they draw on data from the income statement to provide relevant information on the relationship between revenue and expenses.

They also make it possible to compare the company’s results with those of its competitors and to analyse the productivity of the resources used.

Financial ratio	Calculation formula	Objective
Overall profitability	Revenue / Turnover	Measures the impact of costs on the company’s ability to generate sales.
Margin rate	EBE / VA	Measures the company’s ability to generate sales (of goods or services).
Operating gross margin	EBITDA / Turnover (excl. VAT)	Measures the company’s actual profitability and its ability to cover depreciation and amortisation.
Return on equity (ROE)	Nursery / Reception	Measures the return on capital invested in the company.
Production margin rate (mark-up rate)	(Turnover excl. VAT – Purchases excl. VAT) / Turnover excl. VAT	Measures the percentage of turnover remaining after deducting the costs incurred in generating it.
Sales margin	(Turnover excl. VAT – purchases excl. VAT) / purchases	Measures the percentage of turnover remaining after paying for the services required to generate it.
Labour productivity ratio (staff efficiency rate)	Turnover / number of employees	Measures human resource productivity. This ratio is only meaningful when compared with competitors.
Value-added rate	VA / CA	Measures the value actually generated by the company internally.

Where:

• CA stands for turnover.

• EQUITY stands for equity.

• HT stands for 'excluding tax'.

• VA stands for value added. VA = gross margin + production – purchases from third parties.

• NP stands for net profit. NP = operating profit + financial profit + extraordinary profit.

• EBE stands for gross operating profit. EBE = turnover + operating subsidies – purchases from third parties – staff costs – taxes and duties.

To track changes in a company’s profitability over time, we use the rates of change between year N and year N-1.

Financial ratio	Calculation formula	Objective
Activity ratio	(CAN – CAN-1) / CAN-1	Measures changes in turnover from one period to the next
Value-added ratio	(VAN – VAN-1) / VAN-1	Measures the change in value added from one period to the next

This formula can, of course, be applied to any of the company’s financial indicators to determine its year-on-year growth rate.

Coverage ratios

Coverage ratios help to determine the extent to which a company is able to maintain its financial independence at a given point in time in the face of various liabilities. These ratios therefore provide a clear picture of the level of risk assumed by the company.

Financial ratio	Calculation formula	Objective
Financial expense coverage ratio	net financial expenses / VA	Measures the company’s financial independence.
Coverage ratio for long-term loans	annual refunds / CAF*	Measures the company’s financial independence in relation to its long-term borrowings.
Debt coverage ratio	EBITDA / loan and lease payments	Measures the company’s financial independence in relation to its debts.

Cash flow ratios

Cash flow ratios highlight a company’s ability to manage its cash flow and inventory levels, both in terms of payments to suppliers and invoicing of customers.

It is similar to financial balance ratios, which compare a company’s requirements with the resources actually available.

This brings two key concepts into play:

• Working capital requirement (WCR), which is equal to inventories, trade receivables and other receivables minus trade payables, tax liabilities and social security liabilities. A distinction is made between operating working capital requirement (OWCR) and non-operating working capital requirement (NOWCR).

• Total net working capital (TNWC), which is equivalent to permanent capital minus fixed assets. When TNWC is positive, it indicates that the company is solvent.

Good to know: Working capital (BFRE) = current operating assets – current operating liabilities. Non-operating working capital (BFRHE) = current non-operating assets – current non-operating liabilities.

Financial ratio	Calculation formula	Objective
Average payment period for suppliers (in days)	(trade payables incl. VAT / total purchases incl. VAT) × 360	Measures the average length of credit terms granted by suppliers in days.
Average customer payment period (in days)	(trade receivables incl. VAT / turnover incl. VAT) × 360	Measures the average number of days taken to receive payment from customers.
Inventory turnover ratio	(value of stock / total purchases including VAT) × 360	Measures the difficulty in moving stock.
Net cash	cash on the assets side – cash on the liabilities side, or working capital – WCC	Measures the net cash actually available to the company.

Liquidity ratios

Liquidity ratios indicate a company’s ability to meet its short-term financial obligations. Each ratio is calculated based on the assets required to make the various payments.

Financial ratio	Calculation formula	Objective
Liquidity ratio (or general liquidity)	current assets / current liabilities	Measures the company’s ability to repay its short-term debts.
Restricted liquidity ratio	(receivables + cash and cash equivalents) / current liabilities	Measures the company’s limited ability to repay its debts.
Quick ratio	cash and cash equivalents / current liabilities	Measures the company’s ability to repay its debts immediately.
Net gearing ratio	debts / CP	Measures the company’s level of financial independence.

Structural ratios

Structural ratios are based on the balance sheet to provide a more in-depth analysis of the company’s financial position. Assets, liabilities, financing… The data obtained is meaningful both internally and when viewed within the sectoral context.

Financial ratio	Calculation formula	Objective
Asset liquidity ratio	current assets / total assets	Measures the proportion of stock and trade receivables relative to the total balance sheet.
Asset immobilisation ratio	net fixed assets / total assets	Measures the proportion of tangible fixed assets relative to the total balance sheet.
Ageing ratio	net fixed assets / gross fixed assets	Measures the level of wear and tear on fixed assets, i.e. the condition of the production equipment.

Solvency ratios

In addition to coverage and cash flow ratios, solvency ratios assess a company’s ability to generate and retain value (equity and cash flow) in relation to its other resources.

Financial ratio	Calculation formula	Objective
Financial independence ratio	Equity / permanent capital	Measures the company’s ability to finance itself, i.e. its level of financial independence.
Financial independence ratio	Balance sheet / total assets	Measures the proportion of equity capital relative to total capital.
Repayment capacity ratio	Annual capital and interest payments / total repayment instalments on medium-term loans	Measures the company’s ability to repay its debts sooner or later than originally scheduled.

Stock market ratios

In the case of a publicly listed company, other indicators can be used to gauge the value of its shares.

Financial ratio	Calculation formula	Objective
Earnings per share (EPS)	net profit / total number of shares, or	Measures earnings per share.
Price-to-book ratio (PBR)	market capitalisation / equity	Measures the company’s market valuation relative to its equity.
Price-to-earnings ratio (P/E ratio)	market capitalisation / net profit	Measures the share price and helps to identify potential overvaluation or undervaluation.
Dividend per share	total dividend / number of shares	Calculates the dividend per share.
Share yield	dividend / market capitalisation of a share	Measures the return per share.

Financial ratios by business segment

Depending on the sector in which the company operates, other ratios may serve as key performance indicators. In the context of an e-commerce business, for example, ratios such as average basket value, conversion rate and cost per click (CPC) can provide valuable insights at every stage of the user journey.

Of course, there are countless such ratios, and they vary significantly depending on whether the company specialises in providing services or selling goods, and on its core business.

Far more than just a simple percentage, financial ratios are a tool which, when used wisely, provide vital insights into a company’s financial health and performance. What’s more, these ratios are essential for informed decision-making, as well as for successful negotiations!