Measuring Business Success: 5 Ratios Every Owner Should Know
As a business owner, it's essential to have a solid understanding of your financials. This is one of the benefits of having a professional bookkeeper.
While you might not understand everything that the Profit and Loss Account or Balance Sheet tells you, there are some quick rations that every business owner should know. This creates a quick way to monitor your financials and compare them over a number of years.
Measuring Business Success: 5 Ratios Every Owner Should Know
As a business owner, it's essential to have a solid understanding of your financials. This is one of the benefits of having a professional bookkeeper.
While you might not understand everything that the Profit and Loss Account or Balance Sheet tells you, there are some quick rations that every business owner should know. This creates a quick way to monitor your financials and compare them over a number of years.
Key Financial Ratios Every Business Owner Should Know
When it comes to financial ratios, there are several categories to consider. These include liquidity ratios, activity ratios, leverage ratios, profitability ratios, and coverage ratios. In this blog, we'll be discussing one example from each of these categories.
Liquidity Ratios
The first category of financial ratios we'll be discussing is liquidity ratios. These ratios measure a company's ability to pay its short-term obligations. Two of the most important liquidity ratios are the current ratio and the quick ratio.
The current ratio is calculated by dividing current assets by current liabilities. This ratio provides an idea of a company's ability to meet its short-term obligations. A current ratio of 1:1 is ideal, which means a company has enough current assets to cover its current liabilities.
The quick ratio, also known as the acid-test ratio, is calculated by subtracting inventory from current assets and dividing the result by current liabilities. This ratio measures a company's ability to meet its short-term obligations without relying on inventory. A quick ratio of 1:1 is considered healthy.
Activity Ratios
The next category of financial ratios is activity ratios. These ratios measure how efficiently a company uses its assets to generate revenue. Three of the most important activity ratios are inventory turnover, accounts receivable turnover, and total asset turnover.
Inventory turnover is calculated by dividing the cost of goods sold by the average inventory. This ratio measures how quickly a company is selling its inventory. A higher inventory turnover is generally considered to be better, as it indicates a company is turning over its products quickly. A lower ratio means there is a risk of the inventory spoiling or becoming obsolete.
Accounts receivable turnover is calculated by dividing net credit sales by average accounts receivable, or debtors. This ratio measures how quickly a company is collecting payment from its customers. A higher accounts receivable turnover is generally considered to be better, as it indicates a company is collecting payment quickly. The lower the ratio the more likely a business is to experience cash flow problems.
Total asset turnover is calculated by dividing net sales by total assets. This ratio measures a company's efficiency in using its assets to generate revenue. A higher total asset turnover is generally considered to be better, as it indicates a company is using its assets effectively.
Leverage Ratios
The next category of financial ratios is leverage ratios. These ratios measure a company's ability to pay its long-term obligations. Two of the most important leverage ratios are the debt-to-assets ratio and the debt-to-equity ratio.
The debt-to-assets ratio is calculated by dividing total debt by total assets. This ratio measures the proportion of a company's assets that are financed by debt. A lower debt-to-assets ratio is generally considered to be better, as it indicates a company has less debt.
The debt-to-equity ratio is calculated by dividing total debt by shareholder equity. This ratio measures the proportion of a company's financing that comes from debt versus equity. A lower debt-to-equity ratio is generally considered to be better, as it indicates a company is less reliant on debt financing.
Profitability Ratios
The gross profit margin ratio measures the proportion of revenue that exceeds the cost of goods sold (COGS) and is calculated by dividing the difference between revenue and COGS by revenue. This ratio is important for business owners to monitor as it provides insight into a business's profitability, pricing strategy, and overall financial health.
The net profit margin ratio measures the proportion of revenue after all expenses are deducted and is calculated by dividing net profit by revenue. This ratio is important for business owners as it provides insight into the overall profitability and financial health of the business.
The return on assets ratio measures the efficiency of a company's use of assets to generate profit and is calculated by dividing net profit by total assets. This ratio is important for business owners as it provides insight into asset utilisation and overall profitability.
Coverage Ratios
The interest coverage ratio measures a company's ability to pay its interest expenses on debt and is calculated by dividing Earnings Before Interest and Taxes (EBIT) by interest expense. This ratio is important for business owners as it provides insight into financial stability and the ability to meet debt obligations.
The debt service coverage ratio measures a company's ability to pay its debt obligations, including principal and interest, and is calculated by dividing net operating income by total debt service. This ratio is important for business owners as it provides insight into financial stability and the ability to meet debt obligations.
Regularly monitoring financial ratios is crucial for business owners to effectively measure the performance of their business. The 5 key financial ratios discussed in this article include Gross Profit Margin, Net Profit Margin, Return on Assets, Interest Coverage Ratio, and Debt Service Coverage Ratio.
By regularly monitoring these ratios, business owners can make informed decisions, identify trends, and take proactive steps to improve their financial performance. However, it is important to keep in mind that financial ratios are just one piece of the puzzle.
For a more comprehensive understanding of a business's financial health, it is always best to consult with a financial advisor or bookkeeper for assistance in analysing financial ratios and making informed decisions.
Nothing on this page is intended to be or should be construed or taken as accountancy, investment, tax or any other kind of advice. We recommend individuals and companies seek professional advice on their circumstances and matters.