All entrepreneurs should have a basic understanding of financial indicators and concepts. The key financial indicators are profitability, liquidity and capital adequacy. They are calculated based on the company’s financial statements.
Interpreting a mere balance sheet and income statement may prove challenging but, based on the financial indicators and their threshold values, you can much better see the overall picture of your company’s financial situation.
Profitability
Profitability is the foundation for business and it actually is one of the most important financial indicators. Business is profitable when its income exceeds its costs.
If, however, profitability is weak, the business may make a loss. As a result, equity capital in the balance sheet will decrease. At its worst, the capital may be lost altogether, which may prevent access to financing, for example.
Operating profit is a good indicator to monitor profitability. It describes a company’s operating result before depreciation/appreciation, financial items and taxes. So, it shows the amount of profit left after subtracting from net sales all operating costs. A good operating margin varies by industry and no uniform values exist for its interpretation. This is how you calculate the operating profit and operating margin:
- Operating profit = operating result + depreciation/amortisation and impairment loss
- Operating margin = operating profit / net sales x 100
Gross profit shows the amount of profit left after subcontracting all the costs related to selling products or services. The costs are purchase costs and production costs, for example. Gross margin is shown in percentages. A company’s cost structure and line of business have a great effect on the gross margin, so it should not be used to compare companies operating in different industries. This is how you calculate gross profit and gross margin:
- Gross profit = net sales – material costs – external services.
- Gross margin = gross profit/net sales x 100.
Capital adequacy
Capital adequacy ratios describe how a company has been financed, in other words they show the sources of the company’s capital: how much the company has internal finance in relation to debt finance. Poor capital adequacy means that the company has much debt. The higher the ratio of internal finance to debt finance, the more solvent the company is.
A company’s equity ratio is a good indicator to monitor capital adequacy. It is the value of the company’s assets financed using equity. The ratio describes how much of the company’s all financial resources is equity capital. The lower the ratio, the more the business is financed with debt. The ratio is considered excellent if it is over 50 per cent and good if it is 30–50 per cent. This is how you calculate the equity ratio:
Equity ratio = equity/total assets – advances received x 100
Liquidity
Liquidity describes a company’s ability to pay running costs on time, such as wages and salaries and taxes. Liquidity ratios describe the company’s short-term cash position. They show how much the company has funds in its accounts in relation to short-term debts, such as invoices to suppliers.
Quick ratio describes a company’s liquidity. It shows the company’s ability to pay its short-term debts. The ratio measures how well the company could cover its short-term debts with its assets that can be quickly converted to cash, such as cash and marketable securities. The ratio is good if it is at least 1.
This is how you calculate the Quick ratio:
- Quick ratio = short-term receivables + marketable securities + Cash and cash equivalents / short-term liabilities – short-term advances received