To know what is going on in your business, it's important to measure your performance. Financial ratios are one method of measuring performance. You can use four basic financial ratios to track your own performance over time and to compare yourself against other businesses.
Liquidity ratios are used to estimate a company's ability to pay its short-term debts. The two basic liquidity ratios are the current ratio and the quick ratio. The current ratio is calculated by simply dividing current assets by current liabilities. The quick ratio is more stringent, because it does not count inventory as part of the firm's current assets. A higher ratio indicates that a company is better able to pay off its short-term debts.
Asset turnover ratios are used to measure how efficiently a business uses its assets. There are two basic types of asset turnover ratios, receivables turnover and inventory turnover. Receivables turnover measures how efficiently the business collects debts owed to it, while inventory turnover measures how efficiently goods are sold. The basic measure of receivables turnover is annual credit sales divided by accounts receivable. Inventory turnover is measured by dividing the cost of goods sold by the average inventory.
Debt ratios measure a business's debts relative to its equity. Creditors use debt ratios to estimate the risk of lending money to a business; a higher ratio indicates greater debt relative to equity, presenting a greater risk to lenders. The basic debt ratio is measured by simply dividing total liabilities by total assets.
Profitability ratios measure the company's efficiency at generating profits. Some of the basic profitability ratios are return on assets and return on equity. Return on assets is calculated by simply dividing net income by total assets. In the case of return on equity, net income is divided by shareholder equity. In both cases a higher ratio is better, indicating better profit generation.
