If you are a new business owner, or even if you have been an entrepreneur and are now looking for ways to improve your business, it is important to know financial ratios. These ratios will allow you to track and monitor your company’s accounting and bookkeeping process, along with overall fiscal health.
The outcome of these ratios based on your actual accounting records can help you plan for the future. Knowing these figures enable you to make future projections and sound decisions based on facts rather than conjectures. The ten most important financial ratios are divided into four categories. Let’s learn what these are and how to compute for them to aid you in making solid business decisions.
Liquidity Ratios
Liquidity ratios measure your company’s ability to pay its short-term obligations like accrued expenses, accounts payable, and any short-term debt. These ratios often compare current assets: cash, inventory, and receivables. These ratios are:
1. Current Ratio
The current ratio may also be called the capital ratio and is the estimation of the ability to pay short-term obligations within one year.
Current Ratio = Current Assets / Current Liabilities
The ideal ratio is greater than 1, meaning every dollar owed on current liabilities can be settled with your current assets.
2. Quick Ratio
The quick ratio is similar to the current ratio but only looks at the company’s most liquid assets, which include cash, marketable securities, and accounts receivables, as opposed to all current assets.
Quick ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
A quick ratio above 1 is ideal, signifying having enough liquid assets to pay for short-term obligations and maintain your business operations.
3. Days of working capital
Days of working capital is the ratio indicating how many days are necessary to turn your working capital into sales.
Days of working capital = ((Current Assets – Current Liabilities) x (365 [days])) / Revenue from Sales
Having lower days of working capital ratio means your company has a lesser need for financing as it is quick to convert working capital to sales. This information may also be compared to others in your industry to benchmark your growth.
Leverage Ratios
Leverage refers to the amount of debt your company has in its capital structure, which is inclusive of shareholder’s equity and debt. Companies with more than the average debt for their industry have high leverage ratios. This is not necessarily bad, as growing companies may use low-interest rates to grab more market opportunities. However, it is important that the company can afford to make debt payments, or else you run the risk of falling behind and not being able to borrow more money.
4. Debt to equity ratio
This ratio compares total debt to total equity, measuring the risk of the company’s financial structure. Lenders often monitor this ratio, as it can show when companies are taking up too much debt and struggling to pay.
Debt to Equity ratio = (Long-term Debt + Short Term Debt + Leases) / Shareholders’ Equity
An ideal debt-to-equity ratio will vary from one industry to the next, but a ratio of 2 to 2.5 is often viewed as good for most companies.
5. Debt to Total Assets
The debt to total assets ratio shows how much of your company’s assets are financed by creditors.
Debt to total assets = Total Debt/ Total Assets
Having a high debt-to-total asset ratio shows that your company is risky to invest in. The ideal debt to assets ratio is 1 or less.
Asset Management Ratios
These ratios show how efficient a company is in using its assets to generate sales. These are often used by businesses that sell to customers on credit or carry inventory.
6. Inventory turnover
This measures how efficiently you are at managing inventory. A higher inventory ratio means you have good sales.
Inventory Turnover = Cost of Goods Sold / Average Inventory
7. Receivables turnover
Profitability Ratios
These ratios evaluate your company’s ability to generate income or profit. For example, it can help you determine how to raise your prices without losing customers.
- Profit margin
Profit margins show what percentage of sales remains after paying off all business expenses.
Profit Margin = Net income / Net sales
Good profit margins vary per industry, so you may want to, instead, benchmark your ratio against that of other companies.
- Return on Assets
RoA shows how good your company is performing through comparisons of profits to capital invested in assets. A higher RoA means better use of resources.
RoA = Net income / Average total assets
- Return on Equity
RoE measures the company’s ability to use shareholder investments to generate profits. A good RoE is dependent on the industry.
RoE = Net income / Shareholders’ Equity
These are the top ten ratios you must take note of as a business owner. The validity of the computations hinges on proper accounting. We understand that number crunching is not for everyone, so you can count on our team of CPAs for assistance. Together, we can strengthen your company’s fiscal health.
