How’s business? Most business owners can answer that question without consulting a financial statement. But what if someone asks about “return on assets” or “average collection period”? To answer those questions, you need the help of financial ratios.
Inside the Numbers
A financial ratio is the numerical relationship between certain figures on your income statement and balance sheet. “Profit margin” is probably the most familiar financial ratio. Expressed as a percentage, profit margin is calculated by dividing net income by sales.
There are many useful ratios. They can provide information about liquidity, turnover, and debt, as well as profit. Digging “inside” the numbers can reveal such things as how quickly receivables are collected, how frequently inventory is turning over, and whether you’re in a good position to repay your financial obligations on time.
Putting Ratios to Work
While the numbers themselves are interesting, the real value comes from analyzing financial ratios. You can use ratios to spot trends, both good and bad, by comparing your company’s current situation with the past. And ratio analysis can help you with forecasting and goal setting.
Ratios can also be used to compare your company’s financial performance with that of other companies and with the industry as a whole. Another important use: Bankers frequently review a company’s financial ratios as part of the loan application process.
Some Common Ratios
The following key financial ratios are some of the essential business management tools. Each business has its own key performance indicators. Finding the ones that work best for your business will assist you with managing the business efficiently.
| Current Ratio |
Current Assets ÷ Current Liabilities |
Does the company have sufficient resources to meet current liabilities when they come due? This ratio should be greater than 1 to 1. Depending upon the business, this should be 1.25 to 1 or greater. |
| Quick Ratio |
Cash + Accounts Receivable ÷ Current Liabilities |
Does the company have sufficient resources to pay the current liabilities within the terms of the supplier? This ratio maybe less than 1 to 1 if conversion of accounts receivable to cash occurs frequently. |
| Average Collection Period for Accounts Receivable |
Total Accounts Receivable ÷ Sales * Days |
How quickly do customers pay? If payment terms are 1% discount for payment within 10 days and full payment within 30 days, you expect prompt payment. If the average collection period is 45 to 60 days that effects your company’s ability to pay its suppliers. |
| Average Payable Days |
Total Accounts Payable ÷ Cost of Goods Sold * Days |
How quickly are you paying your suppliers? If normal terms are net 30 days, are you meeting these terms? |
| Inventory Turnover or Days Inventory |
Total Inventory ÷ Cost of Goods Sold * Days |
How efficient is your business in handling inventory? Slow inventory turn may result in locked up liquidity in assets not readily saleable. This can effect meeting supplier payment terms. |
| Debt-To-Equity |
Total Liabilities ÷ Stockholders’ Equity |
How heavily is the company leveraged? |
| Gross Profit Margin |
Gross Profit ÷ Sales |
How much profit is available to cover operating expenses? |
| Net Profit Margin |
Net Income ÷ Sales |
How much profit is earned on each sales dollar after all expenses are accounted for? |
| Return on Total Assets or Average Assets |
Net Income ÷ Total Assets
Net Income ÷ Average Assets |
How profitable is the business per each dollar invested in assets? |