To future or present business proprietors, an enhanced understanding of business formulas could help in attaining better precision and clutter free bookkeeping of business transactions. Financial ratios may, however, be important to business owners in a bid to determine the overall viability of their business by calculating the following ratios: Here are a few that you may wish to look at from time to time.
What are Financial Ratios?
The owners of businesses have many tools available to gain better insight into their businesses, and this includes financial ratios. For example, varying figures of certain ratios can provide information regarding the profitability, efficiency, or liquidity position of a business. At other times, these financial ratios are derived by clicking, choosing, and entering the values from the various forms of accounting, such as the balance sheet, the income statement, and the cash flow forecasting statement.
Even though multiple financial ratios are important, they can be categorized into just a few types:
- Financial ratios used to measure liquidity: The types of liquidity ratios include the quick ratio, working capital ratio, free cash flow ratio, and cash ratio. These ratios are the ones that describe the capacity of a business organization to fulfill its short-term commitments and cash flows.
- Financial ratios that assess efficiency: Efficiency ratios include inventory turnover ratios, revenue per employee, and return on total assets. These ratios seek to establish the extent to which an organisation can transform its own assets into sales.
- Financial ratios used to determine solvency: The solvency ratios are the equity ratios and the debt-to-equity ratios. These ratios are normally employed by lenders in the assessment of the capacity of a business to discharge long-term obligations.
- Financial ratios that evaluate profitability: Profitability ratios include return on total assets, return on equity, and the net profit margin ratios. These ratios compute a business’s earning ability from information on its sales, operations, balance sheet assets, and shareholders’ equity. They are the most similar to efficiency ratios in the sense that they consider assets in the capacity of income producers.
7 Key Financial Ratios for Business Owners
Here’s an overview of key financial ratios and why they are so valuable.
1. Quick Ratio
This is a financial ratio that is often used and gives an immediate view of a business’s liquidity. A popular indicator, the quick ratio is calculated by subtracting current inventory from current assets and dividing the result by current liabilities.
This explains how well a business organization’s current assets, or cash, can recover its current liabilities. The business is in a favorable financial position if the quick ratio exceeds one.
2. Working capital ratio
Liability ratios include the working capital ratio, commonly known as the current ratio. Like the quick ratio, this measure assesses the extent to which an organization can meet its existing debts. However, it considers all current assets rather than just liquid assets, meaning that inventory does not need to be subtracted. When expressed as a formula, the working capital ratio appears as follows:
A business will be able to more easily pay off debts using its current assets as the working capital ratio increases.
3. Inventory Turnover Ratio
Stock turnover, or stock turnover ratio, is defined as the speed at which stocks are issued or used within a specific time span. It is a metric that helps businesses manage how frequently certain products are sold and replaced, with the intention of better identifying where the stock might be needed in the future. Indeed, many approaches may be used when calculating this ratio. Consider the following inventory turnover formula:
You can determine the cost of goods sold number to be used in the aforementioned formula by utilizing your income statement and balance sheet. The ebb and flow of inventory can be observed by monitoring your inventory turnover ratio. This can assist you in more accurately predicting the amount of inventory to maintain during a specific time frame.
An inventory turnover ratio may reveal that your business is either frequently out of stock of a specific form of inventory or that it is holding inventory for an excessive amount of time, which is referred to as obsolete inventory. A business is retaining inventory that it may be unable to use or sell as a result of an absence of demand, such as obsolete inventory. It transitions from slow-moving inventory to excess inventory before ultimately becoming obsolete after a specific period of time.
4. Debt-to-Equity Ratio
The debt-to-equity ratio is an additional financial ratio that should be assessed. It evaluates whether a business is financing more than it can reasonably repay by utilizing equity as a metric.
This ratio measures the level of a business’s operations that are supported by borrowing. If the ratio is greater than one, it means the company has more debt. If the value is less than one, it helps to understand that the company has less debt.
5. Return on equity ratio
One has to stay abreast of the return on equity ratio even if you are using your own money to invest or trying to keep the shareholders happy. This financial ratio is very essential in calculating profit by using the formula:
The outcome has been identified as a functionality measure of the overall profitability of the company and is called return on net worth.
6. Net Profit Ratio
It is possible to reach a net profit margin percentage, or a net profit ratio, which can be used in decision-making related to a business, for instance, from pricing goods and services and considering reinvestment. The amount of money that your business has after expenses are paid or accounted for is known as net profit. This may also be referred to as net income or net earnings.
One method of determining the profitability of a business is to calculate its net profit. You may also assess your gross profit, operating profit, and net profit.
7. Gross Profit Margin Ratio
Although the gross margin ratio and net profit ratio are similar, they differ in some key ways. Both are profitability ratios, but the gross profit ratio shows the percentage of revenue a business keeps after covering the cost of goods sold.
This ratio shows how much cash the company keeps after covering the cost of goods sold. You can calculate both the net profit and gross profit margins using their respective formulas.
With the help of these essential financial ratios, small business owners will be able to measure their financial position. By keeping a record of these figures over time, you can identify early risks and adjust profits to help your business stay afloat.
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