Understanding and tracking key financial ratios is a business owner’s best bet and a key ingredient in the recipe for growth and success.
Do you remember your last visit to your doctor? If so, you might also remember how your doctor took various figures from you such as your height, your weight, your body mass index etc.
It is these figures that are used to determine the overall health of the patients. In fact, doctors even use this data to predict what problems the patients might face in the future and what they could do to avoid them.
The main aspect of a business is the ability to make sound decisions and determine your business’s setbacks and success. To do this you will have to measure the overall performance, which can be done by creating and analyzing business financial ratios like the proprietary ratio. Business financial ratios help you compare your current financial numbers to past performances. Additionally, you can use the proprietary ratio formula to make changes to your business in the future. Financial ratios help you provide data so that you can make sound informed decisions, instead of blindly executing operations.
Did you know there are similar figures and data that accountants and business owners use to determine the financial health of a company?
They are financial ratios. These ratios are useful indicators of a firm’s financial performance such as its liquidity, profitability, solvency etc
When it comes to tracking down a few important measures of your business growth, most companies fail to focus on the important parameters. Business owners are often loaded with too much information and stats reports, allaying their decision making powers. Being an owner you need a continuous evaluation of your business trends that may positively influence your decision-making ability. For instance, a project expansion may require you to know if you have operating efficiency or liquidity to toll up with the unforeseen expenses. Similarly, your customers wondering to place a huge order may need enormous credit from you. So I am sure your decision to lend them will be based on your financial ratios. No?
Having learned about your financial ratio is like evaluating whether you will be able to cope with future uncertainties or not. Just for instance, who knew this COVID-19 pandemic would affect the economy at so large? Every business owner no matter how small or large operations it had, has suspected some loss and played unfavorable cards. But those who had their financial health evaluation being done at the right time are surviving it so well. We can call them to be the Jill of all trades for their smart business strategies.
A step back before a step forward
Before taking a dive into understanding the true importance of financial ratios, I suggest you take a quick refresher on financial reporting & its importance to a business.
Understanding financial statements will give you a fair idea as to how financial ratios can be computed with the help of statements such as profit/loss, balance sheet, etc.
Take a few minutes and read: Everything You Need to Know About Business Financial Reporting.
What are business financial ratios?
Accounting or financial ratios are percentages or multiples that help quantify the health of your business. The numbers will portray how your business is doing at a certain point in time. The financial ratios can be calculated when you look at your financial statements, which are balance sheets, income statements, and cash flow statements. Mostly, the ratios are received from the balance or income sheet.
There is no healthy or unhealthy ratio number because they vary in each industry.
All caught up? Good.
Let’s get started!
Here are the top five useful financial ratios that can be calculated from your financial statements and can give you a good picture of a businesses’ health and its efficiency-
1. The Current Ratio
The current ratio is an indication of the firm’s ability to pay back its short-term liabilities. To obtain this ratio, we take all of the current assets and divide them by the current liabilities. If the current ratio is less than one, this indicates the company has more debt due within one year than it has assets it can use to pay those debts.
Formula to Calculate Current Ratio
Current Ratio = Current Assets /Current Liabilities
The Highs and the Lows
Higher the current ratio better the short-term strength of a company, but a deeper analysis of this ratio may also suggest problems such as poor working capital management, stock pile-up, inadequate credit management etc. anything above 2:1 could be considered as high.
On the other hand, a lower current ratio may indicate inadequate working capital & show that the company isn’t sound enough to meet its short-term financial obligations comfortably. A business with low levels may be seen as depending a lot on current liabilities. Anything below 1:1 may be considered as low.
You have $25,000 in current assets while the liabilities land at $10,000 this means your current ratio is 2.5. It subsequently means you have more assets than liabilities to pay debts off.
2. Debt Equity Ratio:
Debt to equity ratio shows the relationship between a company’s total debt with its owner’s capital. It reflects the comparative claims of creditors and shareholders against the total assets of the company. It is a measurement of how much the creditors have committed to the company versus what the shareholders have committed.
Formula to Calculate Debt-Equity Ratio
Debt Equity Ratio=Current Liab. + Non-Current Liab/ Shareholder’s fund
The Highs and the Lows
A lower debt-equity ratio shows that the company is less dependent on borrowed money from outside parties, or in other words, has less debt as compared to its total shareholder’s funds, this is a favorable situation for external parties since they enjoy a higher safety margin.
A higher percentage, on the other hand, shows that the company depends a lot on its debt (borrowed funds + money owed to others) as compared to its shareholder’s funds, this puts external parties at a higher risk.
Apple in the year 2017 had total liabilities of $241 billion while its shareholder’s equity calculated $134billion. Using the formula, its Debt Equity Ratio stood at 1.80. This means Apple had a debt of $1.80 for every dollar of equity.
3. Proprietary Ratio
What is the proprietary ratio? This ratio shows the proportion of total assets of a company which are financed by proprietors’ funds. The proprietary ratio is also known as the equity ratio. It helps to determine the financial strength of a company & is useful for creditors to assess the ratio of shareholders’ funds employed out of total assets of the company.
The word “Proprietors” is a synonym for “owners of a business”, proprietors’ fund, in this case, would only be the funds which belong to the owners/shareholders of the business. Proprietors’ funds are also known as Owners’ funds, Shareholders’ funds, Net Worth, etc.
Formula to Calculate Proprietary Ratio
Proprietary Ratio = Shareholder’s fund /Total Assets
The Highs and the Lows
A higher ratio means sufficient comfort for creditors since it points towards lesser dependence on external sources.
A lower ratio means discomfort for creditors since it shows more dependence on external sources, a lower ratio can be seen as a threat and may increase unwillingness of creditors to extend credit to the company.
Suppose your total assets worth $ 8,00,000 while your stockholder equity is $4,00,000, so your proprietary ratio will be 50%. It means stockholders’ has contributed 50% of the total tangible assets.
4. Fixed Asset Ratio
The fixed asset ratio helps to determine the capacity of a company to liquify or discharge its obligations towards long-term lenders indicating its financial strength and ensuring its long-term survival.
Formula to calculate Fixed Asset Ratio:
Fixed Asset Ratio= Fixed Assets/NonCurrent Liab. + Shareholder’s fund
The Highs and the Lows
A ratio of more than 1 shows that the net fixed assets of the company are more than its long-term funds which depict that the company has bought some of its fixed assets with the help of short-term funds. This depicts operational inefficiency.
Whereas, a fixed asset ratio of less than 1 indicates long-term funds of the company are more than its net fixed assets It is desirable to some extent as it means that a company has sufficient long-term funds to cover its fixed assets.
Suppose your company has a total of fixed assets worth $2,00,000 while long term funds hold value $2,40,000, based on the given information, your FAR is 0.83.
It is also important at this point to mention another key ratio called fixed assets to net worth.
It is calculated using the following formula:
Fixed assets to Net Worth = Net fixed assets / Net worth
Fixed assets to net worth is a ratio that measures the solvency of an organization or business. This ratio indicates the degree to which a business owners’ cash is frozen by means of property, land acreage, operations plant, and related equipment, and the extent to what funds are available for the business’ operations (i.e. working capital).
5. Net Profit Ratio
The net profit ratio helps to determine the overall efficiency of the business’ operations, furthermore, it is also an indicator of how well a company’s trading activities are performing.
The net profit ratio establishes a relationship between net profit earned and net revenue generated from operations (net sales).
Formula to calculate Net Profit Ratio:
Net Profit Ratio= Net Profit/Net Sales
The Highs and The Lows
A high net profit ratio may tell the story of a low direct and indirect costs which results in a higher net profit of the organization.
On the other hand, a low ratio may indicate unnecessarily high direct and indirect costs which will result in a lower net profit of the organization.
Let your net profit be $2,10,000 and net sales be $1,80,000, which means your NPR pins at 1.1.
Why Should You Care About Financial Ratios
When you make use of financial ratios like fixed assets to net worth ratio, it helps compare your current financial status to the past, and the competing businesses in your industry. They will help you focus on the areas where you are financially strong and weak. Here are some main reasons you need to understand why financial health is important.
Versatile and Useful:
The formula of the proprietary ratio is an important quantitative analysis tool. Among the many essential functions, they can act as lagging signs which help identify positive and negative financial trends. The information provided by a trend analysis will allow you to create and launch an ongoing financial plan and make course corrections to short term plans, if necessary.
Efficiency and turnover:
Operating expenses and turnover ratios are essential because they help you assess how efficiently you will handle your business’ assets and liabilities. For instance, the operating ratio compares expenses like rent, inventory purchase, and advertising to sales revenue. A low ratio shows that you are positively managing the business expenses; if you notice a high ratio then you will have to correct your existing financial plans.
Cash and liquidity:
This ratio helps you determine if you can afford to invest in capital assets or long term business growth. The current and working capital ratios are quite useful because they help assess if your business has enough liquidity to pay for daily operating and short term debts.
The numbers in your accounting books tell a story. They show where you’ve been and suggest where you’re headed.
Financial ratios matters to both the business owners and investors in different ways:
For Business Owners
Ratios can provide guidance to entrepreneurs when creating business plans or preparing presentations for lenders and investors. Using industry trends as a baseline, small-business owners can set time-bound performance goals in terms of specific ratios to give investors a glimpse into the potential of the new company.
For Investors & Lenders
Investors and lenders also want to see your financial business ratios. When asking for funding, investors and lenders can determine your business’s profitability and their risk level from ratios. If you want to secure funding, know your numbers as you know yourself.
A Step Further
Computing and interpreting financial ratios are the cornerstones of financial analysis. But what happens when a business outgrows its owner and the complicated figures start to overwhelm him?
For a growing business owner, technology comes to the rescue. Today, cloud-accounting softwares are packed with financial reporting and analysis features enabling business owners and investors alike to make better decisions and carry out their business efficiently.
These accounting solutions do all the hard work of first- generating financial reports like balance sheet and profit/loss statement automatically. And then weeding out the required figures to generate financial ratios.
With the reporting part taken care for, this leaves more time in the hands of the business owner for analysis and decision making.
It’s important for business owners to not get too overwhelmed up on the calculations — as there are multiple online accounting softwares in the market today that would surely help them with the calculations and ratio deductions.
What is more important is that you analyze the results and take action when needed.
What other financial ratios do you think can help a business achieve more? Comment below and let us know!
Financial ratios sum up your business whereabouts in a relatively easy manner. It is a way by which your investors get a clear picture of your operating capacity and the risk levels. The better the graph, the better will be the opportunities for you to grow your business tactics.