Many business owners often overlook the importance of financial ratios. They look at the accounts and the cash in the bank, and they judge the success of the business based on that alone. Looking at the big picture is better than nothing, but the big picture won’t always tell you everything. Financial ratios distill the accounts into key performance indicators. They are very useful for monitoring performance over time. Financial ratios also provide a way to compare a business with its competitors. Here are ten financial ratios that business owners should keep a close eye on.
1. Current Ratio
The current ratio is a liquidity ratio. It is the ratio of the current assets to the current liabilities. If the total current assets were $40,000, and the current liabilities were $20,000, the current ratio would be 2:1. The current ratio shows the business’s ability to pay its short-term creditors.
2. Quick Ratio
The quick ratio is also called the acid test ratio. It is an indicator of the business’s ability to pay debts immediately. The quick ratio is a liquidity ratio that removes inventory from the equation. The formula for the quick ratio is (Total Current Assets – Inventory) / Total Current Liabilities.
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3. Accounts Receivable Turnover
The accounts receivable turnover ratio measures how well a business is collecting money from its sales invoices. A high ratio means that customers are paying their invoices fast. The formula for the accounts receivable turnover is Total Sales / Accounts Receivable. If you had total sales for the year of $100,000, and your year-end accounts receivable totaled $10,000, then your accounts receivable turnover for the year would be 10. That would equate to customers paying their invoices 36.5 days from the date of the invoice.
4. Accounts Payable Turnover
Accounts payable turnover measures how fast a business is paying its suppliers. The equation for the accounts payable turnover is Total Accounts Payable Invoices / Accounts Payable. The benchmarks for all these rations differ for different business sectors. But, if you are slow paying your creditors any business, you may be missing out on early settlement discounts.
5. Inventory Turnover Ratio
The inventory turnover ratio shows the rate at which a business is using its inventory. It demonstrates how efficient the business is at converting inventory into sales. The formula for this ratio is Cost of Goods Sold / Average Inventory. The higher the ratio is, the more efficient the business is at turning inventory into cash.
6. Gross Profit Margin
The gross profit margin is the percentage gross profit made from sales. The formula for gross profit margin is (Sales – Cost of Goods Sold) / Sales. This is an important ratio to track to ensure that a business is maximizing its profits.
7. Net Profit Margin
The net profit margin shows the percentage of profit after all business costs have been deducted. The net profit is what will be available for distribution to equity holders. The net profit margin formula is (Sales – All Costs) / Sales. A falling net profit margin could mean that gross margins are falling or that overheads are increasing.
8. Debt to Equity Ratio
The debt to equity ratio is a measure of how much business relies on debt to fund its operations. It is a good guide to the solvency of a business. The formula for the debt to equity ratio is Total Liabilities / Shareholders Equity. The higher the ratio is, the more reliant on debt the business is.
9. Return on Assets
When a business has invested in assets, it is important to ensure that those assets are generating income. To track the performance of assets, you can use the return on assets ratio, the formula for which is: Net Income / Assets.
10. Return on Investment (ROI)
ROI is an important ratio for small business owners who have invested a lot of their own money in a business. It shows how much income is being generated from the initial investment. The formula for ROI is (Earnings – Initial Investment) / Initial Investment.
The Bottom Line
The above ratios provide a way of analyzing the performance of a business. They can also be used for comparisons with other businesses in the same industry sector. Financial ratios provide a simple way for business owners to drill down into what lies behind the numbers in its accounts. Tracking financial ratios is one of the best ways to see the financial well-being of a business.
About Universal Funding
Universal Funding is a private funding source that has funded thousands of businesses and more than $2 billion since 1998. We turn your accounts receivable into the funding you need through invoice factoring and can have working capital in your hands in a matter of days.