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.
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
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.
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.
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.
3. 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.
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.
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.
Why Should You Care About Financial Ratios
The numbers in your accounting books tell a story. They show where you’ve been and suggest where you’re headed. The 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 is the cornerstone of financial analysis. But what happens when a business outgrows its owner and the complicated figures start to overwhelm him?
For such growing business owners with growing needs, 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!