A few financial ratios can tell you how healthy your business is each month. Track these ratios consistently and you can spot problems brewing and take appropriate actions to improve your business. Lenders love to calculate ratios for your business. This allows them to compare your business to similar businesses to assess risks. You need to know what these ratios mean and how to improve them.

Financial ratios are relationships determined from a company’s financial information and are used for comparison purposes.  These account balances are found on one of the company’s financial statements such as the balance sheet, income statement, cashflow statement, and/or statement of changes in owner’s equity.

 

Current Ratio:

The Current Ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations. This ratio measures whether your business has enough resources to pay its bills (invoices) over the short term. Generally the higher the ratio, the better.  Bankers will rely on this ratio when evaluating your company for a loan.

The formula is:  Current Ratio = Current Assets/Current Liabilities

Total Debt Ratio:

The Total Debt Ratio is a financial ratio that indicates the percentage of a company’s assets that are provided via debt. . This measures your business’s long-term solvency.

The formula is:  Total Debt Ratio = Total Debt/Total Assets

Profit Margin:

This measures profit as a percentage of revenue (sales).  You should try to constantly improve this percentage over time. If the percentage decreases, investigate this for corrective action.

The formula is:  Profit Margin = Net Income/Revenue

 

A  sampling of ratios include:

1.  Short Term Solvency or Liquidity Ratios

  Current ratio = Current assets / Current liabilities

  Quick ratio = (Current assets – inventory) / Current liabilities

  Cash ratio = Cash / Current liabilities

  Net Working Capital = Net working capital / Total assets

  2. Long Term Solvency or Financial Leverage Ratios

  Total debt ratio = (Total assets – total equity) / Total assets

  Debt to Equity ratio = Total debt / Total equity

  Equity Multiplier = Total assets / Total equity

  Long Term Debt ratio = Long Term Debt / (Long Term Debt + Total Equity)

  Times interest earned = Earnings before Interest & Taxes / Interest

  Cash coverage ratio = (Earnings before Interest & Taxes + Depreciation) / Interest

3. Asset Use or Turnover Ratios

  Inventory turnover = Cost of goods sold / Inventory

  Days’ sales in Inventory = 365 days / Inventory turnover

  Receivables turnover = Sales / Accounts receivable

  Days’ sales in receivables = 365 days / Receivables turnover

  Net Working Capital (NWC) turnover = Sales / Net Working Capital

  Fixed asset turnover = Sales / Net fixed assets

  Total asset turnover = Sales / Total assets

4. Profitability Ratios

  Profit Margin = Net income / Sales

  Return on Assets (ROA) = Net income / Total assets

  Return on Equity (ROE) = Net income / Total equity