In this post, we’ll discuss two more ratios you can use to gauge the health of your business. Continuing in our series examining Franchise Financial Performance related to the balance sheet.
Debt-to-Asset Ratio
This financial ratio measures the proportion of a company’s total assets financed by debt. It compares a company’s total liabilities to its total assets and is calculated as follows:
Debt-to-Asset Ratio = Total Liabilities / Total Assets
e.g., if a company has $500,000 in total liabilities and $1,000,000 in total assets, its debt-to-asset ratio would be 0.5:
Debt-to-Asset Ratio = $500,000 / $1,000,000 = 0.5
This means that 50% of the company’s total assets are financed by debt (for every $1 in assets $.50 in debt is financed). The debt-to-asset ratio is used to evaluate a company’s level of financial risk. A higher ratio means that a company has a higher level of debt relative to its assets and this can increase the risk of default. On the other hand, a lower ratio suggests that a company has a more significant equity cushion. They may be in a better financial position to weather economic issues or unexpected events.
Return on Equity Ratio
Return on equity (ROE) is a financial ratio that measures a company’s profitability in relation to its equity. It calculates the net income generated per dollar of equity shareholders invest. The formula for calculating ROE is:
Return on Equity (ROE) = Net Income / Total Equity
e.g., if a company has a net income of $500,000 and total equity of $2,000,000, its ROE would be 25%:
ROE = $500,000 / $2,000,000 = 0.25 or 25%
This means the company made $.25 cents of net income for every dollar of equity invested.
ROE is a key measure of a company’s profitability and is often used by investors to gauge the performance of a company. A high ROE indicates that a company is generating a good return on the equity shareholders invest, which is generally seen as a positive sign.
However, a high ROE may also result from excessive use of debt, which can increase the risk of financial distress or bankruptcy.
Next Steps
Analyzing ROE and debt-to-asset ratios with other financial ratios and qualitative factors is essential for a more comprehensive picture of your franchise business’s financial health. Although different ratios are available, they typically apply to publicly traded companies. In the case of a franchise business, the ratios we’ve covered should be a good starting point to better understanding the health of your business. As always, feel free to reach out or comment on how you use your balance sheet to manage your franchise business.
Here are some helpful links in the Managing Franchise Performance Series:
Don’t take it from me; this link from the Harvard Business Review also shares the importance of the balance sheet now that we’ve wrapped up this series.
