Ratios provide more information about, for example, a company’s profitability, efficiency, and liquidity than absolute amounts.
Profitability
A company’s profitability is a good indicator of whether a company is financially healthy or not. Companies strive to realize the highest possible profit. In theory and practice, we come across the following ratios and critical figures for determining the profitability of a company:
- Added value; the added weight of a company is equal to the turnover minus the direct purchase costs of the turnover. The added value must be positive (> 0). If the added value is negative, it is better to stop your company immediately. Because then the purchase price of the turnover is higher than the selling price.
- Gross profit margin; gross profit margin is gross profit divided by sales. The gross profit margin is an excellent indicator to compare your performance over time. The added value is compared to the turnover in the gross profit margin. The gross profit margin varies significantly by sector. In sectors where the purchase value of sales is high, such as trading companies, the gross profit margin will be substantially lower than in manufacturing or service companies.
- Net profit; the net profit is also an important indicator. Net profit is equal to gross margin minus operating costs. It should be clear that net profit is an important indicator. The net profit must be positive over the years.
- Net profit margin; the net profit margin shows how well a company can turn sales into a profit. The profit percentage is calculated by dividing the net profit by the turnover.
- Profitability of Total Assets (RTV); equals earnings before interest and taxes divided by total capital employed. It shows the percentage of profit over the entire invested capital. This way, you can easily compare the performance of companies within a particular sector.
- Return on Equity (REV); equals net profit divided by shareholders’ equity. It is difficult to say how high the profitability (expressed in %) should be. The return on equity must, in any case, be higher than the market interest rate. Otherwise, it is better just to put the money in the bank because this will yield more.
Liquidity
An organization’s liquidity indicates the extent to which it can meet its obligations in the short term. The organization goes bankrupt when the liquid assets and expected income are insufficient to pay the bills in a short time. The most important indicators to determine the liquidity of a company are:
The current ratio shows the extent to which you have liquid assets to pay your creditors in the short term. This becomes clear by dividing the existing investments by the current liabilities. The desired value for this prefix is between 1 and 1.5.
A quick ratio indicates the extent to which you immediately have liquid assets to pay your creditors. In contrast to the current balance, the quick ratio excludes inventories.
Working capital; is the balance between current assets and current liabilities. This balance, the working capital, indicates the liquidity buffer of a company. It shows the organization’s amount available to absorb financial setbacks without problems.
Solvency
With solvency, it becomes clear whether the organization can repay its debts in the long term. The solvency ratios determine how much an organization finances with equity or loan capital. The higher the proportions, the greater the chance debt providers will get their money back. And the sooner they are willing to make (another) loan available.
Golden Balance Rule means that you must finance the permanently fixed assets and the constant core of the current assets with equity and long-term debt and the fluctuating part of the existing assets with short-term debt.
The debt ratio (solvency ratio); is the total capital expressed as a percentage of the loan capital. This ratio indicates the extent to which assets are covered against the debts. Again a variation on the solvency ratio.
Other Ratios & Key Figures
The ratios and critical figures focusing on profitability provide an important signal about an organization’s performance and financial health. The following percentages and key figures are often used to determine how profitability is achieved.
The turnover rate of assets; if you have the items inventories, debtors, and liquid assets on your balance sheet, you would like to know how efficiently the organization handles this. After all, holding liquid assets and stocks costs money. The ratio ‘speed of turnover’, also called turnover rate, shows whether the invested capital is being used efficiently.
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