Financial ratios are important because they give business owners a way to evaluate the financial performance of their organization.
Have you just started your own business or startup ? Or a seasoned entreprenuer who wants to aid in the expansion of your company? In any scenario, maintaining track of financial ratios will help you analyze your company's financial situation and inform your business decisions.
Undoubtedly, there are dozens or maybe hundreds of potential financial statistics to keep an eye on. So which ones are the most important to you? This blog will help you make a decision.
Financial ratios are important because they allow business owners or founders to evaluate their organization's financial performance independently of its financial statements and in comparison to other organisations in the same industry.
Your Balance sheet, Income statement, and cash flow statement only offer a limited amount of information. Financial ratios go beyond simple statistical analysis to show how well your company gets cash, makes money, grows through sales, and manages costs. They can also act as a warning sign when something is wrong, letting managers and founders know when to make changes.
There are many financial ratios that can be monitored, but the most important ones fall into one of four categories:
Liquidity refers to your company's capacity to cover short-term obligations like accounts payable, accrued expenses, and short-term debt. A company may struggle to pay its creditors, suppliers, and other regular operating expenses when it has liquidity problems, which can lead to major problems.
Liquidity ratios often compare the firm's current liabilities and current assets (cash, inventory, and receivables).
Your capacity to pay short-term commitments, such as liabilities and debts due within a year, is estimated by your current ratio, sometimes referred to as your working capital ratio.
Current Ratio = Current Assets / Current Liabilities
As long as you have enough current assets on hand to pay all of your bills, accrued expenses, and short-term loans, your current ratio should ideally be higher than one.
Quick ratio, also referred as your acid test ratio, serves as a similar indicator to your current ratio of your company's capacity to pay its debts. However, rather of considering all current assets, it solely considers the company's most liquid assets (cash, marketable securities, and accounts receivable). Prepaid expenses are excluded because you cannot use them to settle other short-term obligations, and inventory is excluded because it might take too long to convert it to cash.
Quick Ratio= (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) /Current Liabilities
Days working capital indicates the number of days required to convert your working capital into sales.
Days Working Capital = ((Current Assets - Current Liabilities) x 365) / Revenue from Sales
A high score for days' working capital indicates that it takes your business longer to turn its working capital into cash. Because they utilize working capital effectively, businesses with smaller days' working capital require less funding.
Leverage is the total amount of shareholders' stock and debt in your company's capital structure. If a company has more debt than its peer for its industry, such company is said to be highly leveraged.
Having a high level of leverage is not always a bad thing. Low interest rates on loans could be leveraged by a growing company to seize market opportunities. Being heavily indebted could be a smart business decision, if the company can afford to make loan payments regularly. However, companies who struggle to make their payments may fall and unable to money in future to continue operations.
To assess how risky the company's financial structure is, your debt to equity ratio compares total debt to total equity. This statistic is closely watched by lenders and other creditors because it might indicate when businesses are taking on too much debt and may have problems making payments..
Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity
Your company's percentage of assets that are financed by creditors is indicated by your debt to total assets ratio.
Debt to Total Assets = Total Debt / Total Assets
It is riskier to invest in companies with high debt to total assets ratios because they are payinglarger portion of income to service principle and interest.
Profitability ratios evaluate your ability to generate income (profit) and create value for shareholders.
Your net profit margin ratio calculates how much net income your business makes for every rupees in sales. In other words, it displays the percentage of sales that remain after all costs have been covered by the company.
Profit Margin Ratio = Net Income / Net Sales
A decent profit margin ratio varies by business, thus using a database of profit margins by industry, to compare your performance to that of your rivals is beneficial.
By comparing your profits to the money you spent on assets, return on assets (ROA) shows how well your business is doing. Higher ROA results in more effective use of your financial resources.
Return on Assets = Net Income / Average Total Assets
While comparing your ROA to other businesses in your sector is useful, tracking your return on assets over time is more insightful. The general rule is that if this statistic increases from year to year, you're getting more profits out of each rupee of assets on the balance sheet. However, if your ROA is decreasing, it can indicate that you made some poor business decisions.
Your company's ability to turn a profit from shareholder investments into the business is gauged by your return on equity (ROE).
Return on Equity = Net Income / Shareholders’ Equity
Asset management ratios examine how effectively a business generates sales using its assets. Businesses that carry inventory or sell to clients on credit are often the only ones that employ the following ratios.
How effectively you handle inventory is indicated by your inventory turnover ratio.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Compare your measure to other organizations in your industry when assessing your inventory turnover ratio. Indicators of poor sales or excess inventory include a low inventory turnover ratio relative to the industry norm.
Receivables turnover gauges how quickly you recoup credit sales.
Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable
Comparing your Key metrics to your organization's credit standards and payment terms will help you determine whether your receivables turnover ratio is excellent or poor. If, for instance, your credit terms require customers to pay invoices within 30 calendar days but your receivables turnover reveals that it takes, on average, 45 days to collect payments, you may need to tighten up your collection procedures or have trouble extending credit to customers who are unable to pay.
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