The Purpose of Financial Ratios

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Are you paying all your bills on time? Is your business healthy and strong? How do you know? If you're not tracking the important financial ratios of your business, then you really can't be sure. Financial ratios are the performance metrics that give you information about the health of your business. They tell you if your business is as profitable as it should be and whether you have enough liquidity to pay your debts. These performance gauges fall into four kinds: profitability, liquidity, leverage and operations

Measures of Profitability

How profitable is your business? These metrics show profit results at several points on the income statement:

  • Gross profit margin measures the productivity of your manufacturing or services operations. It is calculated by subtracting the direct labor and material costs of production from sales.

  • Earnings before interest and taxes, EBIT, measures profits after deductions for fixed expenses but before deductions for interest costs from financing arrangements and taxes. This ratio shows the profit-producing ability of the business before the expenses from financial structures and tax planning.

  • Net profits are the final results after paying all expenses. This is the figure that most investors and creditors look at.

Indicators for Liquidity

The primary purpose of the liquidity ratios is to determine the ability of the company to fund its operations and pay its bills on due dates. These are the most common measures:

  • Current ratio is found by dividing current assets by current liabilities. A comfortable ratio is 2:1. The due dates of current liabilities are fixed while the cash conversion cycle from inventory to accounts receivable to cash is less than perfect. Thus, a safe ratio is to have more in current assets than liabilities to allow for disruptions in cash flow.

  • Acid test is a stricter test of liquidity than the current ratio. It measures the ability of the company to pay current debts with only quick assets of cash and current receivables. A ratio of 1:1 means that the company has enough quick assets to pay current liabilities without selling any long-term assets.

  • Working capital is current assets less current liabilities. Companies with positive cash flows should always have increases in working capital.

Leverage Ratios

While increasing debt will improve the return on equity, it also increases risks. Firms with high debt levels are less able to weather economic downturns and declines in sales.

  • Debt-to-equity is the ratio that lenders will look at when gauging the risks of extending more credit. They like to see debt-to-equity ratios around or less than 1:1.

  • Debt-to-assets indicates the amount of assets financed by debt instead of owner's equity.

Performance of Operations

Operations must run smoothly and efficiently to earn profits and maintain liquidity. These metrics are indicators of how well a company turns over its assets in the cash flow cycle:

  • Accounts receivable turnover measures the efficiency of a company at collecting payments from its customers. A company needs to collect its receivables quickly to have cash for paying bills and purchasing more inventory.

  • Inventory turnover is a major focus of management because companies often have large amounts of money invested in inventory.

What Are the Uses of Financial Ratios?

Now that you know the most important financial ratios, how can they help you run your business better? Here are several ways:

  • Ratios identify problem areas that need attention. For example, a current ratio less than 2:1 should alert you to a potential liquidity problem.

  • Comparisons of your company's ratios with industry standards will highlight areas that need improvement to stay competitive. The method of evaluating the firm's performance over time with industry benchmarks is known as comparative analysis.

  • Depending on your goals, financial ratios can give you more insight for analyzing results. For instance, if you've just introduced a new product, inventory turnover will receive special attention.

  • Trends from changes in financial ratios could form the foundation for new policies and strategic planning. A decline in your gross profit margin, as an example, might indicate a need to change the focus of your product mix or to look for lower prices from other suppliers.

Financial ratios are like the instruments on the dashboard of your car. They tell if the engine, known as your company, is running smoothly or if something is sputtering and needs attention. Paying attention to these indicators will help to keep your business on the path to prosperity and profits.

References

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.

Photo Credits

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