As a business owner, you work hard to make your company successful. A financial ratio is a measure of the relationship between two or more components on the company’s financial statements. These ratios give you a quick and straightforward way to track performance, benchmark against those within an industry, spot trouble, and proactively put solutions in place. Whether you go an inch or a mile, you record all your financial moves in your business accounting records.
Financial ratios help make sense of your accounting information. If you simply write down your transactions, you could miss key information about your financial fitness. Ratios show you what aspects of your business are efficient and what are not working.
Financial ratios also compare you see how you stack up against your competitors. They help you identify your gains and weaknesses. Lenders look at ratios when you apply for a loan.
Why Is Measuring Financial Ratios Important?
Financial ratios are important tools for quantitative analysis. Certain ratios are available to evaluate both short- and long-term financial and operational performance. It identifies trends in the business and providing warning signs when it may be time to make a change.
And if the business is seeking outside funding from a bank or an investor, financial ratios provide those stakeholders information if the business will be able to pay the money back and produce a strong return on investment.
The importance and uses of ratio analysis:
- Analysis of Financial Statements
- Helps in Understanding the Profitability of the Company
- Analysis of Operational Efficiency of the Firms
- Liquidity of the Firms
- Helps in Identifying the Business Risks of the Firm
- Helps in Identifying the Financial Risks of the Company
- For Planning and Future Forecasting of the Firm
- To Compare the Performance of the Firms
Statements to use
Many ratios come from two financial statements: the balance sheet and the income statement.
- The balance sheet shows your business’s net value. It includes your assets, liabilities, and equity.
- The income statement includes all the money coming in and out of your business. It shows how you use assets and liabilities.
Financial Ratios for Business
1. Quick ratio
A quick ratio also called the acid test shows if you can meet financial obligations, even if something unexpected happens. This ratio subtracts inventories from current assets, before dividing that figure into liabilities
Quick Ratio = (Total Current Assets – Total Current Inventory) / Total Current Liabilities
2. Current ratio
A current ratio shows your present financial strength. It is similar to its quick ratio and investors also use it to determine a business’s liquidity. It represents how many times bigger your current assets are compared to your current liabilities. This is also called a working capital ratio.
Current Ratio = Total Current Assets to Total Current Liabilities
3. Inventory turnover ratio
An inventory turnover ratio reveals how frequently you convert inventory into sales. It shows how much product is sold and how efficiently you manage inventory.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
4. ROI (return on investment)
ROI compares the amount of money an investment brings into your business to how much you paid for the investment. This ratio shows the money you invest and the profit you get back from it.
ROI = (Earnings – Initial Cost of Investment) / Initial Cost of Investment
5. Working capital or current ratio:
Working capital represents the difference between a firm’s current assets and current liabilities. Assessing the health of a company in which you want to invest involves understanding its liquidity How easily that company can turn assets into cash to pay short-term. The working capital ratio is calculated by dividing current assets by current liabilities.
Working capital ratio = current assets/current liabilities
6. Cash ratio:
This measure is similar to the working capital ratio but only takes cash and cash equivalents into account. This will not include inventory. Cash equivalents are investments that mature within 90 days, such as some short-term bonds and treasury bills.
Cash ratio = cash and cash equivalents/current liabilities
7. Earnings per Share (EPS)
When buying a stock, you participate in the future earnings (or risk of loss) of the company. Earnings per share (EPS) measures the net income earned on each share of a company’s common stock. The company’s analysts divide its net income by the weighted average number of common shares outstanding during the year. If a company has zero or negative earnings (i.e. a loss) then earnings per share will also be zero or negative.
8. Debt-Equity Ratio
A debt-equity ratio compares a firm’s long-term debt with a stockholder’s equity or owner’s equity. Essentially, the debt-equity ratio expresses a firm’s long-term debt as a percentage of its owner’s equity.
Long-term debt/stockholder’s equity
9. Cash flow to debt ratio:
Measures how much of the business’ debt could be paid with the operating cash flow. Another way of looking at it is that the business can cover its liabilities twice over.
Cash flow to debt ratio = operating cash flow/debt
There are a couple of ways to calculate the operating cash flow. One is to subtract operating expenses from total revenue. This is known as the direct method.
10. Total assets turnover ratio
The total assets turnover ratio also measures how efficiently you’re employing your assets. This ratio is probably more appropriate in the situation where a firm doesn’t have a lot of fixed assets, but the firm still wins or loses at the game of business based on how well the firm manages its assets.
As we have discussed, the importance and uses of ratio analysis. These ratios analysis are widely used for making important decisions and future forecasting