Financial ratios provide a useful way to pinpoint strengths and weaknesses in the performance and solvency of your business. Here are four types of ratios that you can monitor using the figures from your balance sheet.
- Liquidity ratios, such as the current ratio, measure the ability to pay bills over the next 12 months. You compute the current ratio by dividing current assets (cash, receivables, inventory, and other assets expected to be converted to cash within a year) by current liabilities (financial obligations expected to be settled within a year). A current ratio greater than one is generally considered healthy.
- Asset turnover ratios indicate how efficiently your business is using assets. For instance, receivables turnover (annual credit sales divided by accounts receivable) reveals how quickly your business collects accounts receivable. Inventory turnover (cost of goods sold divided by average inventory level within a given time period) tells you how often your inventory is moving.
- Financial leverage ratios address your company’s long-term solvency. An example is the debt ratio, which is total liabilities divided by total assets. A debt ratio greater than one may be reason for concern.
- Profitability ratios measure your business’s success at generating profits. One profitability margin you may be familiar with is the profit margin. You calculate your profit margin by dividing net income by sales. Here’s an illustration: Say your net income is $30,000 and sales are $150,000. Your net profit margin is 20% ($30,000/$150,000).
How do you know if a financial ratio is good or bad? One way is to compare the ratio to the same ratios from previous periods. You can also use comparisons to similar companies or to your business forecasts.
Contact us for more details about how ratios can help you assess the health of your business.