To understand your business, you have to understand the numbers. Even if you’re not mathematically inclined, or you have a degree in engineering instead of accounting, there are some simple financial ratios that will give you a quick, high-level view of your business without having to bother your CPA.
These ratios measure the relationship between two or more elements of your company’s financial statements. Tracking and comparing the results over several accounting periods allows you to follow trends in your company’s performance and uncover signs of trouble so adjustments can be made. Bottom line – they can prove invaluable in maintaining the financial health of your business.
Leverage ratios (or solvency ratios)
- Debt to equity ratio = Total liabilities / Shareholders’ equity
Measures how much debt a business is carrying compared to the amount its owners have invested. This ratio is often used by potential lenders to measure the business’s capacity to repay its debts.
- Debt ratio = Total liabilities / Total assets
Shows the percentage of a company’s assets that are financed by creditors. The higher the ratio, the more dependent the company is on debt, which could indicate financial weakness.
- Current ratio = Current assets / Current liabilities
This indicator shows whether a business has sufficient cash flow to meet short-term obligations. A ratio of 1 or greater is considered acceptable for most businesses.
- Cash ratio = Cash and cash equivalents / Current liabilities
Provides a snapshot of a business’s ability to repay current obligations with its most liquid assets, as it excludes inventory and prepaid items for which cash cannot be obtained immediately.
- Net profit margin = After tax net profit / Net sales
Shows the net income generated by each dollar of sales. It represents the percentage of revenue retained by the company after operating expenses, interest, and taxes have been paid.
- Return on equity = Net income / Shareholders’ equity
Indicates the amount of after-tax profit generated for each dollar the company’s owners have invested. Basically a measure of the rate of return the shareholders received on their investment.
- Coverage ratio = Profit before interest and taxes / Annual interest and bank charges
An indicator of the business’s capacity to generate adequate income to repay interest on its debt.
- Return on total assets = Income from operations / Total assets
Measures the efficiency of assets in generating profit.
- Accounts receivable turnover = Net sales / Average accounts receivable
Measures how many times a company can turn receivables into cash over a given period. A higher turnover rate generally suggests customers are paying on time and less money is tied up in accounts receivable.
- Days outstanding = Days in the period X Average accounts receivable / Total amount of net credit sales in period
Indicates the amount of time customers are taking to pay their bills.
- Average days payable = Days in the period X Average accounts payable / Total amount of purchases on credit
Measures the average number of days you are taking to pay suppliers.
- Inventory turnover = Cost of goods sold / Average inventory
Measures how many times a company’s inventory is sold and replaced over a given period. Generally, the higher the turnover, the more efficient the company is at producing and selling its products.
You may find that adding some of these ratios to your key performance indicator (KPI) dashboard broadens your perspective of the business, by giving you more insight into how certain activities affect cash flow and your bottom line. Incorporating them into your quarterly financial review also allows you to measure your company’s performance against other similar businesses in your industry. And if you ever need money from investors or lenders, they’ll insist that you have a firm grasp of these metrics.
There are many more standard ratios used to measure a company’s health, so feel free to explore what other indicators may help you fine tune your business. You may even find that creating your own internal ratios are more meaningful to your business than ones you find in your research. In short, the use of financial ratios will expand your view of your business’s performance, simplify the management of your finances, and make you a better business owner.