A financial or accounting ratio is a valuable tool all entrepreneurs must know for a viable business. Each financial ratio, as we have outlined in this masterpiece, has a purpose. However, financial ratios predominantly play a critical role in evaluating a company’s progress against its present goals, competitors, and applicable industry.
Yes, regular bookkeeping and the knack for navigating financial statements can play a critical role in the success of your venture. However, if you want to take your organization to a new level, embrace some ratio analysis. A financial ratio is a relative magnitude of two or more entries from an enterprise’s financial statements.
Financial ratios, unlike efficacious accounting, are somewhat complex and challenging to analyze. Nevertheless, with the following insights, entrepreneurs can seamlessly calculate these ratios from their financial statements giving a lucid picture of their businesses’ health and efficiency.
Financial Ratios to Know as an Entrepreneur
The following are the four most prevalent ratios in the business realm.
Liquidity ratios calculate the business’s ability to pay debt obligations. That is if a firm can use the current or liquid assets to cover its current liabilities. Primarily, creditors and investors use the liquidity ratio to determine whether they should invest or extend credit to an organization.
There are three commonly used liquidity ratios: current ratio, quick ratio, and cash ratio. To calculate these ratios, you should divide the existing and liquid assets by the current liabilities. A ratio above 1 implies that the organization is in a “good position.” That is, it can pay all of its current liabilities with the existing assets. On the other hand, anything below 1 indicates the firm can’t settle its current liabilities.
All in all, creditors and investors prefer businesses with an accounting liquidity ratio of around 2 or 3. Still, if your venture records a substantial amount of liquidity ratio, it would be best to invest more in long-term growth.
The current ratio is the most straightforward ( to calculate and understand ) type of liquidity ratio. It shows the ability of the business to generate cash, current assets that can be used to cover debts.
Current Ratio = Current Assets / Current Liabilities.
The Quick ratio or the acid test ratio is a little more complex than the current ratio. Still, it’s a more reliable or genuine test to indicate a firm’s ability to cover its short-term obligations. Only particular types of assets are used. They include liquid assets such as cash, account receivables, and marketable securities.
Cash Ratio = ( Cash + Account receivables + Marketable securities ) / Current Liabilities.
As the name gives it away, profitability ratios evaluate whether a business can generate income relative to its operating costs, balance sheet assets, and shareholders’ equity within a particular duration. In short, profitability ratios elucidate how well an enterprise uses its assets to produce profit and value to shareholders.
As you can imagine, higher ratios indicate your business is well off by creating revenues, profits, and steady cash flow. In most cases, profitability ratios are helpful when comparing your organization with your competitors, your history, or average ratios in your industry.
Here are different types of profitability ratios:
Net Profit Margin
Net profit margins give insight into how profitable a business is after considering all the expenses, including interest and taxes.
Net Profit Margin = Net income / Total revenue
Operating Profit Margin
It measures a firm’s earnings before deducting interest expenses and income taxes ( EBIT ). A high operating profit margin implies that the organization can pay the fixed cost, interest on obligations, increased chances of surviving economic slowdowns, and, importantly, offer relatively lower prices than their competitors with a low-profit margin.
Return on Assets (ROA)
ROA provides insights into a company’s net earnings relative to the total assets. That is the percentage of a firm’s net income by total average assets. For example, businesses with a ROA of 5% are well off. In short, a higher ROA implies the company is productive in generating profits.
Return on Equity (ROE)
ROE calculates the company’s ability to earn on its equity investments. In Layman’s terms, how much it makes for each invested shilling. As a result, the ROE is mainly on the watchlist of stock analysts and investors. As you can insinuate, individuals are likely to purchase stocks from firms with a favorably high ROE.
Leverage ratios give insight into how much capital comes in the form of debts. In short, it evaluates the ability of a business to meet its financial obligations. It indicates the level of debt an enterprise incurs against other accounts such as balance sheet, income statement, and cash flow statement.
The two most prevalent types of leverage ratios, debt-to-equity ratio, and debt-to-asset ratio, primarily give an idea of how changes in output impact operating income.
The debt-to-equity ratio calculates the total debt incurred to run a firm’s operations ( Total debt / Total equity ). On the other hand, the debt-to-asset ratio determines the percentage of a firm’s assets financed by beneficiaries. ( Total debt / Total assets )
For a healthy entity, the balance between assets provided through debt and assets provided by the firm’s investors should be outstanding. Also, creditors value businesses that these ratios are on the low end.
These ratios analyze how effectively an organization utilizes its assets and liabilities or resources to generate income. Efficiency ratios, or activity ratios, primarily act as a comparison of expenses incurred to profits generated. Consequently, a company can gauge the kind of profits it can make from daily business operations.
Inventory Turnover Ratio is a typical efficiency ratio that calculates the duration of time a business sells and replaces its inventory within a year. That is; (Cost of Goods Sold / Average Inventory )
Other efficiency ratios include:
- Accounts Receivable Turnover Ratio: ( Net Credit Sales / Average Accounts Receivables ) This ratio calculates revenue collection ability.
- Assets Turnover Ratio: ( Net sales / Average Total Assets )
- Accounts Payable Turnover Ratio: This ratio indicates how frequently a business pays off its creditors during an accounting period.
The Bottom Line
These are some of the essential and prevalent financial ratios to know as an entrepreneur. They give an acumen to every financial aspect of your organization. It’s best to combine these ratios to get a vivid picture of your firm’s prospects.