Ratios come in various ways and are used to gather further insights form the financial statements and financial data. At their core, a ratio is just trying to put into perspective and compare key information with each other. Take for example one of the most common ratios, the debt ratio, otherwise known as the debt to assets ratio. Here, you are taking the total liabilities or debts that you owe as a business and dividing it by the total amount of assets or in other words the total value that your business controls financially. The output is the amount of debt you have for every dollar of value you control, or you have in assets.

For example, if you have 1 million in assets and half a million in liabilities, then you would have a debt ratio of 0.5, meaning if you were to liquidate everything today, you would be able to pay back all your debts and walk away with half a million.

It should be noted that ratios are all about perspective. Different industry and company sizes all will have different levels of what is considered a healthy level for the various ratios. Companies that are selling commodity items such as food, and most retailers, will typically have a higher level of turnover as compared to luxury items or higher priced items. As opposed to many service-based businesses, likely do not hold much in the way of liquid cash, especially if they do not have employees, or take ownership of many materials or supplies.

Below are some great resources to learn more about and find more examples of ratios

4 types of financial ratios to assess your business performance | BDC.ca

Financial Ratios – Complete List and Guide to All Financial Ratios (corporatefinanceinstitute.com)

Profitability ratios

Profitability ratios are all about if you can turn a profit. Some common ones you can find below

• Return on Assets (ROA): outputs for every dollar of assets how much profit is being generated. Typically, the higher the better, it also tells how efficient your assets are. ROA=Net Income/Total Assets

• Return on Equity (ROE): outputs for every dollar of equity how much profit is being generated. Typically, the higher the better, it also tells how efficient your equity stakes are. ROE=Net Income/Total Equity

• Net profit margin tells you for every dollar of revenue how much is being converted into profit. Net Profit Margin=Net Income/Total Revenue

• Gross Margin: Tells you for every dollar of revenue, how much is being generated in Gross Profit. Gross profit is the profit after your account for the cost of the goods sold, which can roughly tell if you are generating enough profits from the actual items prior to looking at the operational costs. Your cost of goods sold are the direct cost to acquire your inventory. Whether that be the direct manufacturing costs of direct labour, materials and direct overheads, or the price you paid to purchase your inventory. Gross Margin=Gross profit/total Revenue

Activity ratios

Activity ratios tell you how efficient you are being with your expenses and are in line with the liquidity ratios that we will discuss next. The two most important ratios are regarding how quickly you can turn over your inventory and receivables and turn them back into cash, which can then be used to create more inventory or profit. In addition, you have an equal one on your liabilities side, identifying how quickly you are turning over your payables. A general rule of thumb is the lower ratio the better, as that means you will be paying back your creditors faster and turning over your inventory quicker and receiving payment more favourably. It should be noted that there are no standards on what makes a perfect number, and generally dependent on the industry.

Average days in Inventory: Measures the average number of days it takes for you to turnover your inventory. First you must calculate your average inventory for the period, which may be counter intuitive, but you just take the beginning balance and the ending balance and divide by 2.

Avg. Inv. = (Beg Inv. + End Inv.)/2

Then you multiply the average by the days in the period typically one year so 365. Then divide it by the COGS.

Avg. days in Inventory = (Avg. inv.*days in period)/COGS

Average days in payables: Tells you how fast you can payback your Accounts Payable (A/P). Similar formula to average days in inventory, however you sub out inventory for accounts payable.

Avg. A/P = (Beg A/P + End A/P)/2

Avg. days in payables= (Avg. A/P*days in period)/cost of goods sold

Days in Receivable (average collection period): Similar as average days in payables, however, instead of dividing by COGS at the end you take the Average of Accounts Receivables (A/R) multiplied by the days in period and divide that by the Revenues.

Avg. A/R = (Beg A/R + End A/R)/2

Days in Receivable = (Avg. A/R*days in period)/Revenue

Liquidity ratios

Liquidity is all about your current portion of your financials and your ability to pay back your debts or current portion of your debt and ensure that you can stay afloat for the year. In this context the term current means less than one year. A current asset would mean an asset that is typically going to be used in less than one year such as inventory or collected in the case of accounts receivable. Something that can be turned to cash (made liquid) quickly, is another great way to define current assets. Current liabilities are along a similar line in that they are to be paid back in less than one year, typically includes accounts payable, and the interest and principal payments to be made that year. Below are some examples of Liquidity ratios

Current Ratio: Tells you if your current assets are enough to cover your current liabilities, and if so by what margin.

Current Ratio = Total Current Assets/Total Current Liabilities

Quick Ratio: tells if you have enough cash to cover your current liabilities and by what margin.

Quick Ratio = Cash/Total Current liabilities

If you are noticing that you have liquidity issues, they can be resolved depending on your situation.  Mainly, an adjustment in your spending and trying to find efficiencies in your cash management, which the next set of ratios can help isolate and help lead you towards finding a solution.

Solvency Ratios

If liquidity is all about the current portion, then solvency ratios are about the big picture. These ratios compare if you currently in a position to cover your debts.

Solvencies ratios are the most influential ratios as they tell the long-term health of the business. The more the business is leveraged the more it is insolvent. This means the business will have less to cover its debts. Compared to liquidity issues, solvency issues are much more difficult to find solutions to. As the more insolvent you become that harder it is to raise capital for your business to grow and expand.

Below are some examples of key Solvency Ratios

Debt to Assets: one of the most common financial ratios, which is where you take your total liabilities and divide it by the total Assets. It then determines, as mentioned previous, if you have enough assets to cover all your debts.

Debt to Assets = Total Assets/Total Liabilities

Debt to Equity: Shows how your business is being financed, is it predominantly debt financed (a higher ratio) or is more funded by investors (lower ratios).

Debt to Equity = Total Liabilities/Total Equity

Debt Servicing Ratio (DSR): is a special solvency ratio that calculates your ability to repay your debts known as servicing the debt. A ratio that is more than 1.25 is ideal.

It is calculated taking your EBITDA and dividing it by your current debt obligations.

EBITDA is your Earnings Before Interest, Taxes Depreciation and Amortization. It is calculated, as you may assume, by taking your profit prior to deducting any interest and taxes, and then adding back in the depreciation and amortization expenses. Your current portion of long-term debt is the total interest and principal payments you will have to make over the next year.

DSR = EBITDA/(Interest + Current portion of long-term debt)