How to Interpret Key Financial Ratios in Business Valuations

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Financial ratios serve as benchmarks for comparing companies. At Objective Investment Banking & Valuations, we specialize in business valuation to ensure that your company transcends mere financial ratios on a page. In this article we will review how investors calculate and interpret these key indicators in order to evaluate a company’s profitability, solvency, efficiency, growth potential, and business valuation. The following guide to business valuation will provide you with an explanation of some of the most commonly used financial ratios and how they are calculated.

Understanding Financial Ratios

Financial ratios are a series of key indicators that show investors information about a company’s financial condition by comparing two financial values. The ROI (Return on Investment), for instance, is a financial ratio that, when calculated, shows how much profit a business makes relative to its total investment. 

There are a number of different financial ratios that can tell you much more about an enterprise’s fiscal health, indicating its profits, debts, working capital, efficiency, market valuations and even its asset management. As a good rule of thumb, these values are normally calculated using the data published by a company in its annual reports. The main types of financial ratios are as follows.

Profitability Ratios & Their Impact

Profitability ratios are a class of financial metrics used to assess a business’s ability to generate profit relative to its revenue, operating costs, balance sheet assets, and shareholders’ equity over time. They show how well a company utilizes its assets to produce profit. A higher ratio is always more favorable and indicates the organization’s financial health. The five main types of profitability ratios are return on investment (ROI), return on equity (ROE), operating margin, net profit margin, and gross profit margin. 

Buying and investing in a business are both influenced by profitability ratios. Regarding investing, taking the time to analyze a potential investment can help an investor determine whether an investment can be made profitably or whether it would be more profitable elsewhere. As for buying a business, understanding a company’s profitability directly impacts the establishment of its financial well-being. 

Liquidity Ratios: Analyzing Business Solvency

Liquidity ratios determine the company’s ability to meet its short-term financial obligations, such as salaries, debt, invoices, and other short-term costs. The primary liquidity ratios are the current ratio (current assets/current liabilities), which measures if there is enough in the tank to fund this quarter’s financial obligations, and the quick ratio (current assets – inventory/current liabilities), which measures the value of company’s liquid quick assets available to pay this quarter’s liabilities.

So, the company is in good liquidity when it has current assets (cash, bonds, mutual funds, etc.) to pay its immediate expenses. Bad liquidity means the company doesn’t have enough and has become insolvent. In its simplest form, if the liquidity ratios turn negative, the company will run out of cash and be near bankruptcy.

Debt Ratios: Assessing Financial Leverage

Debt ratios come next. These financial ratios measure how much a company uses debt relative to its investments or capital. In other words, the ratio tells us what percent of the company’s capital structure is financed through debt. Debt ratios can further be delineated into various types, the most popular being the debt-to-asset ratio, debt-to-equity ratio, and debt-to-capital ratio.

Debt ratios are important in the valuation of a business because they show the degree to which a company is using financial leverage. In other words, what percentage of the company’s assets would have to be sold to repay its debt. A very high debt ratio can indicate that the company is highly leveraged and, therefore, risky to the investor. However, this is not always the case. If a firm is generating a very healthy profit and has a high Liquidity Ratio (can make its debt payments), there may not be a problem with a high debt ratio. In this instance, we defer to the adage, “It takes money to make money.”

Efficiency Ratios: Evaluating Operational Performance

Investors use efficiency ratios to determine how effectively a firm uses its resources and capital to generate sales and income. Some of these include Inventory Turnover (Cost of Goods Sold/Average Inventory), Account Receivable Turnover (Net Credit Sales/Account Receivable), and Account Payable Turnover (Net Credit Purchase/Average Account Payable).

Analyzing these proportions is an easy way of understanding the efficiency or inefficiency of a corporation with respect to the resources it uses as well as time. Combining these with other calculations, such as profitability, investors are able to obtain a sense of the financial status and the value of the business.

Market Valuation Ratios

These ratios concentrate on a company’s market value (share price) as compared to definitive equity or book value. These include the price-to-earnings ratio, which is the share price divided by earnings per share. Then we have the price-to-book ratio, which is market capitalization over the book value of equity.

And lastly, we have the price-to-sales ratio, where market capitalization is divided by revenue.
These ratios are essential for business valuation as they give clear and simple insights into what calculable value this company really has without being influenced by irrelevant data.

Conclusion

Financial ratios analysis provide a quick and relatively simple way to assess the financial health of a company. The insight obtained from the analysis can add value in terms of both business valuation and investing. All you need is historical data to calculate these ratios, and you can easily identify whether a company is a profitable investment or a failing business.

FAQ

What are the most critical financial ratios for business valuation?

Of all the financial ratios considered for business valuation, some of the most critical are profitability, liquidity, and debt ratios.

How do profitability ratios affect business valuation?

Profitability ratios can affect business valuation in both good and bad ways. Typically, when the profitability ratio is high, it has a positive effect on the valuation of a business, meaning when the ratio increases, it improves the valuation.

Why are liquidity ratios important in assessing a company’s financial health?

Liquidity ratios are important to assess the ability of a company to meet its immediate financial obligations.

How does debt impact business valuation?

Debt can heavily affect a business’s valuation as a means of assessing risk and, therefore, greatly altering its value.

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