While often overlooked, financial ratios are important financial tools that can enhance your understanding about what is going on in your business and may even give you warnings about potential future problems. All the information you need to make the calculations is on your financial statements.
The following are commonly used ratios along with a brief description about how they are useful.
This is probably the most widely used ratio. It measures a business’ ability to meet its obligations by comparing assets to liabilities.
The formula is: Current Assets / Current Liabilities
The total for your Current Assets and Current Liabilities can be found on your Balance Sheet. The number that results after the calculation should be a positive number, i.e., one or higher.
If you’re current ratio is less than one, you don’t have enough assets on hand to cover your existing obligations and are suffering from liquidity problems.
This is another way to analyze liquidity, but it’s a tougher standard than the Current Ratio because it excludes inventory from the formula.
The formula is: (Current Assets – Inventory) / Current Liabilities
For businesses with large inventories, this measure gives you a solid picture of your actual liquidity status. As with Current Ratio, the Quick Ratio should be a positive number of one (1) or higher.
Inventory Turnover Ratio
This will show you how often your inventory turns over (is sold) during the year. This number will help you to understand how long your inventory sits before being sold.
The formula is: Cost of Goods Sold / Average Inventory Value
This ratio is best calculated on twelve months of data to be effective. A high number means your inventory is flowing through quickly and a low number may show that your cash flow is being negatively impacted because your inventory is sitting in the warehouse too long.
Debt to Equity Ratio
This ratio will indicate whether your company is carrying too much debt.
The formula is: Total Liabilities / Total Equity
The definition of a healthy ratio varies widely by the nature of your industry, so you want to have a ratio that makes sense with your type of business. This ratio is a good indicator of how solid your balance sheet is.
Return on Sales Ratio
This ratio shows how much after-tax profit you are making on sales.
The formula is: Net Profit / Sales
A low number may indicate that you need to re-examine your pricing and product margins.
Average Collection Ratio
This tells you how fast your customers are paying your invoices. It is a bad sign if this number starts to rise, as it indicates your collections are
The formula is: Accounts Receivable / (Annual Sales / 365)
Ideally this number is as close to your terms (e.g., net 30) as possible. If this ratio indicates a log lag time from your terms, you may need to work on your collection and billing procedures.
Using these and other ratios will supplement the other financial information you review. This will help give you a solid understanding of how your business is doing and point out where there may be some potential problems coming down the road, like aging receivables.