Every Small Business Owner Should Be Aware of Financial Ratios
Are you just getting started in the world of business? Or are you an experienced business owner looking to take your firm to the next level? Financial ratios can help you examine your company’s financial status and make more educated business strategies in either case.
They are tools investors and banks use to assess a company’s stability. Financial auditors who need insight into a company’s financial accounts use them as well. They can, however, be as beneficial to small business owners.
We’ll go through what a financial ratio is, the best financial ratios to follow for a small business, and how to get the most information out of them. So, which ones are the most crucial to you?
What Is the Significance of Financial Ratios?
Financial ratios are essential because they allow business owners to assess financial performance outside of income statements and compare it to that of other companies in their industry.
Your financial statement, net income, and cash flow statement are all beneficial, but they only provide a limited amount of information. Financial ratios go further than the statistics to demonstrate how well your firm manages its finances, profits, revenues, and expenses. They can also serve as a warning indication that something isn’t quite right, alerting business owners to the need for change.
The Best Financial Ratios to Track
You can track a large number of ratios, but to avoid becoming overwhelmed, you should limit yourself to a small number of ratios.
These are the ratios you should include in your shortlist:
Liquidity Ratio – What Is It?
Liquidity is a metric that measures your company’s capacity to meet short-term obligations like accounts payable, accrued liabilities, and short-term debt. When a firm is experiencing liquidity issues, it may have difficulty paying employees and suppliers. As well as covering other everyday running expenses, resulting in major issues.
Current assets are generally compared to current liabilities in liquidity ratios.
The term “current assets” refers to firm resources that you will utilize within a year. Money, current receivables, inventories, prepaid expenses, and other short-term assets are only a few examples. Current obligations, on the other side, are debts or liabilities that you need to pay within a year. Accounts payable, short-term obligations, accrued expenses, government payables, and so on are some examples.
The optimal current-to-voltage ratio is two. It means there should be two current assets for everyone’s current liability.
Leverage Ratios 101
The amount of debt in your company’s capital structure, which incorporates both debt and shareholders’ equity, is referred to as leverage. A corporation that has more debt than the industry average is said to be highly leveraged.
Having a high level of leverage isn’t always a bad thing. A growing company can use low-interest rates to grab market possibilities. As long as the company can easily afford to make loan repayments, being highly leveraged could be a sensible business option.
Companies that have difficulty making debt payments, on the other hand, may fall behind and be unable to borrow further funds to stay afloat.
The following are the most common forms of leverage ratios:
Debt ratio – calculated by multiplying total liabilities by total assets. As a result, you’ll get the percentage of the company’s debts. To break it down, it is the ratio of the creditors’ portion of the company’s total assets to the company’s total assets. This should be under 50%, at the very least. Since the corporation is handing away 50% of the company to creditors, anything above it indicates the company’s aggressive plan. It’s as if you’re working for the creditors of the company.
Equity ratio – calculated by dividing total assets by total equities. As a result, you’ll get the proportion of overall owner shares of the company. In simple terms, it is the ratio of the stockholders’ share of the firm’s total assets to the total assets of the company. This should, at the very least, be higher than 50%. Anything below indicates the corporation’s aggressive strategy, as they are keeping a smaller portion of the company.
What Are Profitability Ratios?
The ability to generate earnings (profit) and enhance shareholder value is measured using profitability ratios.
The profitability ratio’s purpose is to determine whether your company is overspending or underspending. As well as whether it can generate sales given the number of resources it has invested. The profitability ratio might assist you to figure out if you’re using your overall assets or investments too much or too little.
The following are the most common profitability ratios:
- The gross profit margin – You can calculate it by dividing total sales by gross profit.
- Net Profit Margin – You can calculate by multiplying net profit by total sales. The term “net profit margin” refers to the proportion of a company’s overall profit after you deduct all costs and expenses.
- The Return on Assets (ROA) – You can calculate it by dividing net income (profit) by total assets. Return on Assets (ROA) is a metric that determines whether a company’s total asset investment yielded a profit. You can use it to figure out what proportion of revenue the total assets invested. You may also use ROA to assess how long it will take the company to return its total asset investment.
Speak With Your Part Time Accountant
These major financial ratios are critical analysis techniques that company owners may use to swiftly assess the profitability and success of their organization. You may recognize hazards before they become issues and make adjustments to enhance your bottom line by tracking these data over time.
It all starts with good bookkeeping, of course. Your Part Time Accountant assists you in staying on top of your company’s success by providing you with all of the data you need to compute key financial ratios.