5 Need-To-Know Financial Ratios
Financial ratios are used by investors, bankers, and accountants to analyze a company’s financial health.
Ratio analysis is a form of analysis that links together the financial statements commonly produced by corporations.
As a result, ratios provide useful figures that are comparable across industries. Using financial ratios, we can develop a feel for a company’s financial strength and profitability.
How to determine the financial health of any company
1) Quick Ratio
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The quick ratio measures a company’s ability to meet its short-term obligations (its liquidity). Therefore, the higher the quick ratio, the better off the company is in its ability to pay its debts.
2) Total Debt-to-Equity Ratio
Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity
The goal of the debt-to-equity ratio is to find out how a company is financing its growth. A high ratio means that the company has used a lot of debt to grow its operations. Even though not all debt is bad, if the number is really high, it’s important to consider other factors too. For example, the debt amount used in this ratio doesn’t include the interest payments they also need to repay.
3) Gross Profit Margin
Gross Proft Margin = (Revenue – Cost of Goods Sold) / Revenue
The gross profit margin is a profitability ratio that measures how much revenue is left over after all costs involved with selling the products or services are removed. For example, if I sell a product for $50 and it costs me $25 to purchase, my gross profit margin is 50% [($50-$25)/$50].
4) Receivables Turnover
Receivables Turnover = Revenue / Average Accounts Receivables
The receivables turnover ratio is an activity ratio that measures a company’s effectiveness in collecting its credit sales. Given that, it indicates how many times per period the company collects and turns its customers’ accounts receivable into cash. For example,
5) Payables Turnover
Payables Turnover = Purchases Made on Credit / Average Accounts Payable
This ratio measures how quickly a company pays off the money owed to suppliers. A high number indicates that the firm is paying off creditors quickly, and vice versa. Measure this ratio against other companies in the same industry and of the same size.
Financial ratios don’t just show how a company is performing, they also measure the effectiveness of the people behind the business and how well they are running the show.
Banks use ratios to assess your business when deciding on whether or not to approve loans. The ratios help them decide your company’s ability to repay its debts. They also help them find any risk factors they need to consider when making lending decisions.
That said, ratios aren’t the only ways to evaluate how well a company is doing. But, they are a starting point and one of the first steps taken by investors and lenders. Therefore, it’s important for business owners to know what they are and how to calculate them. Becoming familiar with ratios will allow you to make more informed decisions.
Want to understand more about financial ratios? Contact me and book an appointment for a full review of where your company stands.