Control ratios are financial metrics used by businesses to monitor and manage various aspects of their operations. They are calculated by comparing certain financial figures, such as revenues or expenses, to other figures, such as assets or sales, to measure the effectiveness of a company’s operations and financial management.
There are several types of control ratios that businesses can use to measure their financial performance and control over their operations. In this article, we will explain the most commonly used control ratios, along with their formulas, components, and functions.
Profitability Ratios:
Profitability ratios are used to measure a business’s ability to generate profits from its operations. These ratios are important because they indicate whether a company is earning enough to cover its expenses and generate a return for its investors. Some of the commonly used profitability ratios are:
- Gross Profit Margin: Gross profit margin is a ratio that measures the percentage of sales revenue that exceeds the cost of goods sold. This ratio indicates how efficiently a company is managing its production costs and pricing its products. The formula for gross profit margin is:
Gross Profit Margin = (Gross Profit / Sales Revenue) x 100
Gross Profit = Sales Revenue – Cost of Goods Sold
- Net Profit Margin: Net profit margin is a ratio that measures the percentage of sales revenue that remains after deducting all expenses, including taxes and interest. This ratio indicates how efficiently a company is managing its costs and generating profits. The formula for net profit margin is:
Net Profit Margin = (Net Profit / Sales Revenue) x 100
Net Profit = Gross Profit – Operating Expenses – Taxes – Interest
- Return on Assets (ROA): Return on assets is a ratio that measures the percentage of profits generated by a company’s assets. This ratio indicates how effectively a company is using its assets to generate profits. The formula for ROA is:
ROA = (Net Profit / Total Assets) x 100
- Return on Equity (ROE): Return on equity is a ratio that measures the percentage of profits generated by a company’s equity (i.e., the money invested by its shareholders). This ratio indicates how effectively a company is using its equity to generate profits. The formula for ROE is:
ROE = (Net Profit / Shareholders’ Equity) x 100
| Profitability Ratio | Formula |
| Gross profit margin ratio | (Net sales – Cost of goods sold) / Net sales |
| Operating profit margin ratio | Operating income / Net sales |
| Net profit margin ratio | Net income / Net sales |
| Return on assets (ROA) ratio | Net income / Average total assets |
| Return on equity (ROE) ratio | Net income / Average shareholders’ equity |
| Earnings per share (EPS) ratio | (Net income – Preferred dividends) / Weighted average common shares outstanding |
Efficiency Ratios:
Efficiency ratios are used to measure a business’s ability to use its resources effectively to generate revenue and profits. These ratios are important because they indicate how efficiently a company is using its assets and resources to generate revenue and profits. Some of the commonly used efficiency ratios are:
- Inventory Turnover Ratio: Inventory turnover ratio is a ratio that measures how quickly a company is selling its inventory. This ratio indicates how effectively a company is managing its inventory and production processes. The formula for inventory turnover ratio is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
- Accounts Receivable Turnover Ratio: Accounts receivable turnover ratio is a ratio that measures how quickly a company is collecting its accounts receivable (i.e., the money owed to it by customers). This ratio indicates how effectively a company is managing its accounts receivable and cash flow. The formula for accounts receivable turnover ratio is:
Accounts Receivable Turnover Ratio = Sales Revenue / Average Accounts Receivable
- Accounts Payable Turnover Ratio: Accounts payable turnover ratio is a ratio that measures how quickly a company is paying its accounts payable (i.e., the money it owes to suppliers and vendors). This ratio indicates how effectively a company is managing its accounts payable and cash flow. The formula for accounts payable turnover ratio is:
Accounts Payable Turnover Ratio = Cost of Goods Sold / Average Accounts Payable
- Total Asset Turnover Ratio:
This ratio measures how efficiently a company is using all of its assets to generate revenue. It is calculated by dividing the total revenue by the average total assets during the period.
Total Asset Turnover Ratio = Total Revenue / Average Total Assets
Accounts Payable Turnover Ratio:
This ratio measures how quickly a company is paying its accounts payable. It is calculated by dividing the cost of goods sold by the average accounts payable balance during the period.
Accounts Payable Turnover Ratio = Cost of Goods Sold / Average Accounts Payable
Working Capital Turnover Ratio:
This ratio measures how efficiently a company is using its working capital to generate revenue. It is calculated by dividing the total revenue by the average working capital during the period.
Working Capital Turnover Ratio = Total Revenue / Average Working Capital
Sales to Working Capital Ratio:
This ratio measures the proportion of sales that are generated by each dollar of working capital. It is calculated by dividing the total revenue by the working capital.
Sales to Working Capital Ratio = Total Revenue / Working Capital
| Efficiency Ratio | Formula |
| Asset turnover ratio | Net sales / Average total assets |
| Inventory turnover ratio | Cost of goods sold / Average inventory |
| Days inventory outstanding | (Average inventory / Cost of goods sold) x 365 |
| Accounts receivable turnover ratio | Net credit sales / Average accounts receivable |
| Days sales outstanding | (Average accounts receivable / Net credit sales) x 365 |
| Fixed asset turnover ratio | Net sales / Average fixed assets |
Liquidity ratios
Liquidity ratios are used to measure a company’s ability to meet its short-term obligations. Here are some commonly used liquidity ratios with their formulas:
Current Ratio:
This ratio measures a company’s ability to pay its short-term debts using its current assets. It is calculated by dividing the current assets by the current liabilities.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio:
This ratio measures a company’s ability to pay its short-term debts using its most liquid assets. It is calculated by dividing the current assets minus inventory by the current liabilities.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Cash Ratio:
This ratio measures a company’s ability to pay its short-term debts using its cash and cash equivalents. It is calculated by dividing the cash and cash equivalents by the current liabilities.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Net Working Capital Ratio:
This ratio measures a company’s ability to pay its short-term debts using its net working capital. It is calculated by subtracting the current liabilities from the current assets.
Net Working Capital Ratio = Current Assets – Current Liabilities
Operating Cash Flow Ratio:
This ratio measures a company’s ability to generate cash flow from its operations to pay its short-term debts. It is calculated by dividing the operating cash flow by the current liabilities.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Accounts Receivable Turnover Ratio:
This ratio measures how quickly a company is collecting its accounts receivable. It is calculated by dividing the net credit sales by the average accounts receivable balance during the period.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
| Liquidity Ratio | Formula |
| Current ratio | Current assets / Current liabilities |
| Quick ratio | (Current assets – Inventory) / Current liabilities |
| Cash ratio | Cash and cash equivalents / Current liabilities |
| Operating cash flow ratio | Cash flows from operating activities / Current liabilities |
| Receivables turnover ratio | Net credit sales / Average accounts receivable |
| Days sales outstanding | (Average accounts receivable / Net credit sales) x 365 |
Solvency ratios
| Solvency Ratio | Formula |
| Debt-to-equity ratio | Total debt / Total equity |
| Debt ratio | Total debt / Total assets |
| Interest coverage ratio | Earnings before interest and taxes (EBIT) / Interest expense |
| Debt service coverage ratio | Net operating income / Total debt service |
| Fixed charge coverage ratio | (EBIT + Lease payments) / (Interest + Lease payments) |
| Cash coverage ratio | (Cash flows from operating activities + Interest paid + Taxes paid) / Interest paid |
Leverage Ratios
Leverage ratios are financial ratios that measure a company’s ability to meet its long-term obligations and its overall debt load. Here are some commonly used leverage ratios with their formulas:
Debt-to-Equity Ratio:
This ratio measures the proportion of debt to equity in a company’s capital structure. It is calculated by dividing the total liabilities by the total equity.
Debt-to-Equity Ratio = Total Liabilities / Total Equity
Debt-to-Assets Ratio:
This ratio measures the proportion of a company’s assets that are financed by debt. It is calculated by dividing the total liabilities by the total assets.
Debt-to-Assets Ratio = Total Liabilities / Total Assets
Interest Coverage Ratio:
This ratio measures a company’s ability to pay its interest expense on outstanding debt. It is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expense.
Interest Coverage Ratio = EBIT / Interest Expense
Debt Service Coverage Ratio:
This ratio measures a company’s ability to meet its debt obligations, including principal and interest payments. It is calculated by dividing the company’s net operating income by the total debt service.
Debt Service Coverage Ratio = Net Operating Income / Total Debt Service
Fixed Charge Coverage Ratio:
This ratio measures a company’s ability to cover all of its fixed expenses, including interest and lease payments. It is calculated by dividing the earnings before interest, taxes, depreciation, and amortization (EBITDA) by the sum of the interest expense and lease payments.
Fixed Charge Coverage Ratio = EBITDA / (Interest Expense + Lease Payments)
Debt-to-Capital Ratio:
This ratio measures the proportion of a company’s capital structure that is financed by debt. It is calculated by dividing the total debt by the sum of the total debt and total equity.
Debt-to-Capital Ratio = Total Debt / (Total Debt + Total Equity)
| Leverage Ratio | Formula |
| Debt-to-equity ratio | Total debt / Total equity |
| Debt ratio | Total debt / Total assets |
| Interest coverage ratio | Earnings before interest and taxes (EBIT) / Interest expense |
| Debt service coverage ratio | Net operating income / Total debt service |
| Fixed charge coverage ratio | (EBIT + Lease payments) / (Interest + Lease payments) |
| Times interest earned ratio | Earnings before interest and taxes (EBIT) / Interest expense |
| Debt-to-capitalization ratio | Total debt / (Total debt + Total equity) |
| Capitalization ratio | Long-term debt / (Long-term debt + Total equity) |
| Equity multiplier | Total assets / Total equity |
Coverage Ratios
Coverage ratios are financial ratios that measure a company’s ability to meet its financial obligations. These ratios help investors and creditors assess a company’s ability to pay its debts, including interest and principal payments. Here are some commonly used coverage ratios with their formulas:
Interest Coverage Ratio:
This ratio measures a company’s ability to pay interest on its outstanding debt. It is calculated by dividing the company’s earnings before interest and taxes (EBIT) by the interest expense.
Interest Coverage Ratio = EBIT / Interest Expense
Debt Service Coverage Ratio:
This ratio measures a company’s ability to meet its debt obligations, including principal and interest payments. It is calculated by dividing the company’s net operating income by the total debt service.
Debt Service Coverage Ratio = Net Operating Income / Total Debt Service
Fixed Charge Coverage Ratio:
This ratio measures a company’s ability to cover all of its fixed expenses, including interest and lease payments. It is calculated by dividing the earnings before interest, taxes, depreciation, and amortization (EBITDA) by the sum of the interest expense and lease payments.
Fixed Charge Coverage Ratio = EBITDA / (Interest Expense + Lease Payments)
Cash Coverage Ratio:
This ratio measures a company’s ability to meet its interest payments with its cash flow. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by the interest expense.
Cash Coverage Ratio = EBITDA / Interest Expense
Asset Coverage Ratio:
This ratio measures a company’s ability to meet its debt obligations with its assets. It is calculated by dividing the company’s total assets by its total debt.
Asset Coverage Ratio = Total Assets / Total Debt
| Coverage Ratio | Formula |
| Debt service coverage ratio | Net operating income / Total debt service |
| Fixed charge coverage ratio | (EBIT + Lease payments) / (Interest + Lease payments) |
| Times interest earned ratio | Earnings before interest and taxes (EBIT) / Interest expense |
| Cash coverage ratio | (Cash flow from operations + Interest paid + Taxes paid) / Interest paid |
| Dividend coverage ratio | (Net income – Preferred dividends) / Common dividends |
| Capital expenditure coverage ratio | (Operating cash flow – Dividends) / Capital expenditures |
| Current ratio | Current assets / Current liabilities |
| Quick ratio | (Current assets – Inventory) / Current liabilities |
Activity Ratios
Activity ratios, also known as efficiency ratios, measure a company’s ability to convert its assets into revenue. These ratios help investors and creditors assess a company’s operational efficiency and effectiveness.
Here are some commonly used activity ratios with their formulas:
Inventory Turnover Ratio:
This ratio measures how many times a company sells and replaces its inventory during a period. It is calculated by dividing the cost of goods sold by the average inventory.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Accounts Receivable Turnover Ratio:
This ratio measures how many times a company collects its accounts receivable during a period. It is calculated by dividing the total credit sales by the average accounts receivable.
Accounts Receivable Turnover Ratio = Total Credit Sales / Average Accounts Receivable
Accounts Payable Turnover Ratio:
This ratio measures how many times a company pays its accounts payable during a period. It is calculated by dividing the total credit purchases by the average accounts payable.
Accounts Payable Turnover Ratio = Total Credit Purchases / Average Accounts Payable
Asset Turnover Ratio:
This ratio measures how efficiently a company uses its assets to generate revenue. It is calculated by dividing the total revenue by the average total assets.
Asset Turnover Ratio = Total Revenue / Average Total Assets
Fixed Asset Turnover Ratio:
This ratio measures how efficiently a company uses its fixed assets to generate revenue. It is calculated by dividing the total revenue by the average net fixed assets.
Fixed Asset Turnover Ratio = Total Revenue / Average Net Fixed Assets
| Activity Ratio | Formula |
| Inventory turnover ratio | Cost of goods sold / Average inventory |
| Days inventory outstanding | (Average inventory / Cost of goods sold) x 365 |
| Accounts receivable turnover ratio | Net credit sales / Average accounts receivable |
| Days sales outstanding | (Average accounts receivable / Net credit sales) x 365 |
| Fixed asset turnover ratio | Net sales / Average fixed assets |
| Total asset turnover ratio | Net sales / Average total assets |
Pros:
- Provides a standardized way to monitor financial performance: Control ratios provide a standardized way to monitor financial performance across different time periods and companies, making it easier to compare financial performance and identify trends.
- Helps identify potential areas for improvement: By analyzing control ratios, organizations can identify potential areas for improvement and take proactive steps to address them.
- Facilitates decision-making: Control ratios can provide decision-makers with valuable information that can help them make informed decisions about resource allocation, budgeting, and other financial matters.
- Enables organizations to set benchmarks: Control ratios enable organizations to set benchmarks and compare their financial performance against industry standards or other organizations in the same sector.
Cons:
- Limitations of financial ratios: Control ratios are based on financial ratios, which have limitations. For example, financial ratios are backward-looking and may not reflect current economic conditions or future trends.
- Limited scope: Control ratios only provide a snapshot of an organization’s financial performance and may not capture other important factors such as market trends, customer preferences, or technological advances.
- Over-reliance on ratios: Organizations may become overly reliant on control ratios and overlook other important factors that can affect financial performance, such as strategic planning or operational efficiencies.
- Difficulty in selecting appropriate ratios: Selecting the appropriate control ratios can be challenging, as different ratios may be relevant to different industries and organizations.