Financial ratios highlight the health and stability of any business. They help investors, credit partners and managers gauge the pulse of its performance. These are the key concepts founders need to know.
Profitability Ratios measure how efficiently a company generates profit relative to its revenue, assets, or shareholders’ equity. They are calculated using the following 4 ratios:
Gross Profit Margin
Net Profit Margin
Return on Equity (ROE)
Return on Assets (ROA)
ROA is a crucial metric because it reflects how effectively a company is using its assets to generate profit, serving as a key indicator of overall efficiency and business effectiveness. For founders, ROA offers insights into whether the resources they've invested—such as equipment, inventory, and intellectual property—are being utilized to maximize returns. A strong ROA suggests the company is not only growing but doing so in a resource-efficient manner, which is vital for long-term sustainability and profitability. Typically, an ROA between 5-10% is considered average, below 5% is weak, and above 10% is strong.
Let’s take a look at FIGS, Inc. (NYSE: FIGS; www.wearFIGS.com) ROA over the past two years. In 2022, their ROA was 5.4%, which falls into the fairly average range. However, in 2023, despite increasing their total assets by nearly 20% (19.85%), their net income only grew by 6.8%. These changes resulted in a 10% decrease in ROA year-over-year, bringing it down to 4.8%, which puts them on the cusp of average and below average. Upon further analysis, the increase in Total Assets primarily stems from an expansion in their Property and equipment and Operating lease right-of-use assets, indicating that Figs is gearing up for future growth.
Liquidity Ratios are the ways to evaluate a company’s ability to meet short-term obligations. They are calculated by looking at the Current Ratio and Quick Ratio (Acid - Test Ratio)
Current Ratio is a commonly used liquidity ratio that compares current assets to current liabilities. A higher ratio indicates better short-term financial health. While it can be industry specific, a good Current Ratio is generally considered to be between 1.5 and 2.0.
At FIGS, we see in 2022, their Current Ratio was sitting at 4.1, so in a very healthy place. As we move to 2023, we see their Current Assets increase by 8.2% and their Current Liabilities increased by 10.3% leading to a 2% decrease in their Current Ratio. Although they saw a slight decrease, they are still sitting at a very healthy Current Ratio of 4.
Leverage/Solvency Ratios reveal how a company is using borrowed money (debt) to finance its operations. They are evaluated by looking at the Debt-to-Equity Ratio and Interest Coverage Ratio.
The Debt-to-Equity Ratio is a key leverage metric, comparing the company’s total liabilities to its shareholder equity. High leverage can amplify returns, but it also increases financial risk.
Efficiency Ratios evaluate how well a company is using its assets and managing its liabilities. They are calculated by looking at these 3 ratios:
Inventory Turnover Ratio
Receivables Turnover Ratio
Asset Turnover Ratio
The Asset Turnover Ratio is a crucial metric for founders because it measures how efficiently a company uses its assets to generate sales. A higher ratio indicates the company is effectively leveraging its assets to drive revenue, which is crucial for maximizing growth and profitability. This ratio provides insight into operational efficiency and resource management, helping them assess whether their investment in assets is yielding sufficient returns. A good Asset Turnover Ratio generally varies by industry, but as a rule of thumb, a ratio of 1.0 or higher is often considered strong. This indicates that the company generates $1 or more in sales for every $1 of assets it owns, reflecting efficient use of its assets to drive revenue. As we continue our analysis of FIGS, we see that although their Asset Turnover Ratio declined 10% from 2022 to 2023, they have maintained above a 1 in both years.
Market Share Ratios help investors determine the attractiveness of a stock relative to its price. These are calculated by looking at Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio and Dividend Yield. The Price-to-Earnings (P/E) Ratio, for example, compares a company’s stock price to its earnings per share. A lower P/E ratio may indicate that a stock is undervalued, while a higher ratio could suggest overvaluation. For FIGS, the Price-to-Earnings (P/E) ratio was 56.1 at the end of 2022, and it increased to 70.6 by 2023.
Financial ratios are essential for several reasons:
Decision-Making: If you’re an investor, a manager, or a creditor, financial ratios help you to assess a company’s financial stability, profitability, and overall performance, enabling you to make more accurate predictions about its future.
Comparability: By standardizing financial data, these ratios let you compare companies of different sizes and industries on an equal footing. This is particularly useful when trying to identify industry leaders or potential investment opportunities.
Trend Analysis: Ratios aren’t just useful for a single point in time; they’re invaluable for tracking a company’s performance over time. By analyzing trends in these ratios, you can identify patterns that might indicate growth, decline, or potential red flags.
Risk Assessment: Financial ratios also play a critical role in assessing risk. For instance, a company with a high Debt-to-Equity Ratio might be more vulnerable in an economic downturn, while a low Current Ratio could signal liquidity issues. Understanding these risks allow you to make more prudent financial decisions.
Financial ratios serve as a critical tool for distilling large amounts of data into actionable insights. These metrics are key during the credit underwriting credit process for raising capital as they provide a clear, concise, and comparative look at the financial health of a company. Understanding how your company sits will help you to navigate the world of finance with greater confidence.
For detailed information on these metrics and further insights into FIGS' financial performance, you can refer to their official financial reports and updates available on their investor relations website(WearFIGS). Other figures were obtained from the company’s financial reports and detailed on the financial analysis platform CompaniesMarketCap.
