Business owners can use financial ratios as vital instruments to assess their company’s financial condition, detect patterns and take well-informed actions. They provide a comprehension of diverse factors of a business, for instance, profitability, liquidity, efficiency and stability. By grasping the importance of principal financial ratios, entrepreneurs can effectively control their finances and take wise decisions.
In this article, we will discuss some of the key financial ratios that every business owner should know.
1. Gross profit margin:
To determine a company’s profitability, the gross profit margin is used. This calculation involves subtracting the cost of goods sold (COGS) from the revenue and expressing the remaining percentage. A larger gross profit margin is a sign that a business is proficient in cost management and can earn more income from sales. The following equation can be used to calculate the gross profit margin.
Gross profit margin = (Revenue – COGS) / Revenue
2. Net profit margin:
The net profit margin is a metric that assesses a company’s profitability by determining the portion of revenue that remains after subtracting all costs, such as COGS, operating expenses, taxes, and interest expenses. It indicates a company’s capability to generate profits from its operations. The net profit margin can be calculated using the formula below.
Net profit margin = Net profit / Revenue
3. Return on equity (ROE):
The ROE is a measurement of a company’s ability to generate profit for its shareholders by determining the percentage of net income earned on the equity of the shareholders. A greater ROE suggests that the company is efficiently utilizing the equity of its shareholders to produce profit. To calculate the ROE, use the following formula:
ROE = Net income / Shareholders’ equity
4. Current ratio:
The current ratio is a metric that evaluates a firm’s capacity to meet its short-term obligations with its short-term assets. It contrasts the organization’s current liabilities to its current assets. When the current ratio is high, it implies that the company has enough short-term assets to fulfill its short-term obligations. The calculation for the current ratio is as follows:
Current ratio = Current assets / Current liabilities
5. Quick ratio:
The quick ratio is comparable to the current ratio but does not include inventory in current assets, given that it may not be easy to convert inventory into cash rapidly. The quick ratio assesses a business’s capacity to settle its short-term debts using its most liquid assets. Its calculation formula is as follows:
Quick ratio = (Current assets – Inventory) / Current liabilities
6. Debt-to-equity ratio:
The debt-to-equity ratio evaluates the level of debt that a company holds compared to its equity. It compares the total liabilities of the company to the shareholder equity. A high debt-to-equity ratio implies that the company depends greatly on debt financing. To determine the debt-to-equity ratio, you can use the following formula:
Debt-to-equity ratio = Total liabilities / Shareholders’ equity
7. Asset turnover ratio (Return on total assets):
The asset turnover ratio determines the effectiveness of a company’s use of their assets to generate revenue. It computes the revenue generated per dollar of assets. A greater asset turnover ratio suggests that a company is effectively utilizing their assets to create revenue. To calculate the asset turnover ratio, use the following formula:
Asset turnover ratio = Revenue / Total assets
8. Accounts receivable turnover ratio:
The speed at which a company obtains payment from its clients is measured by this proportion. It gauges how many times a company’s accounts receivable is gathered during a designated time frame. A greater accounts receivable turnover ratio shows that a company is proficiently handling its accounts receivable. To calculate the accounts receivable turnover ratio, you can use this formula:
Accounts receivable turnover ratio = Revenue / Accounts receivable
9. Inventory turnover ratio:
The inventory turnover ratio is a measure of a company’s inventory management efficiency, which is determined by how many times inventory is sold and replenished in a specific timeframe. A higher ratio indicates effective inventory management and no unnecessary inventory. The inventory turnover ratio can be calculated using the following formula:
Inventory turnover ratio = Cost of goods sold / Average inventory
10. Return on assets (ROA):
The efficiency of a company in generating profit is measured by this ratio, which determines the percentage of net income earned in proportion to its total assets. A higher ROA implies that a company is more effective in generating profit from its assets. The ROA can be calculated by using the following formula:
ROA = Net income / Total assets
11. Cash flow to debt:
The financial ratio known as the cash flow to debt ratio determines a company’s capacity to produce sufficient cash flow from its operations to fulfill its debt obligations. Its significance lies in its ability to give an idea about the company’s ability to meet its debt obligations and steer clear of default.
The formula for calculating the cash flow to debt ratio is as follows:
Cash flow to debt ratio = Operating cash flow / Total debt
Cash flow from operations comprises the cash produced through a company’s daily activities such as sales, receipt of payments, and disbursements to suppliers and staff. The aggregate debt encompasses the entire short-term and long-term debt liabilities of a company.
If a company has a cash flow to debt ratio of less than 1, it suggests that the company could struggle to pay off its debts. However, if the ratio is greater than 1, it implies that the company produces adequate cash flow to meet its debt payments.
Understanding and monitoring key financial ratios is essential for every business owner. By analyzing these ratios, business owners can identify areas that require improvement, make informed decisions and take corrective actions. Business owners should regularly track their financial ratios to identify trends, benchmark against industry standards and assess their financial health. However, it is important to note that financial ratios should not be viewed in isolation, but rather as part of a comprehensive financial analysis of the company’s performance. In addition, ratios should be used in conjunction with other financial metrics and qualitative factors to make informed business decisions.