Important Financial Ratios for a Business

Important Financial Ratios that a Business Should Know
Important Financial Ratios that a Business Should Know

For any organization, whether small, mid-sized or large, it is important that management and stakeholders know the strengths and weaknesses of the business. You need to know how your company has been performing over a period of time, and what its status is at any given point in time. Are you meeting your goals? Are your targets too high and therefore unachievable? How are your competitors faring as compared to you? What changes should you make in your operations?

Financial ratios provide the answers to all these questions. There are hundreds of financial ratios. Any set of numbers can be compared to another set of numbers. However, all of them are not required. Only those ratios need to be chosen that are applicable for your business.

 Key Financial Ratios That Your Business Should Know

  1. Operating Margins:

    How much money do you have left after paying the cost of raw materials, salaries and other operating expenses? For the answer, divide Operating Income by Net Sales.

    Operating Margins = Operating Income / Net Sales

    A high ratio is good. But if it is low, then it probably implies that the business does not generate enough revenue to pay off debt and other expenses.

    A variance on this formula is the Net Profit Margin, which is the percentage of revenue remaining after all operating expenses, interest, taxes and preferred stock dividends (but not common stock dividends) have been deducted from a company’s total revenue.

    Net Profit Margin = Net Income / Sales

  1. Return on Equity:

    Your shareholders are always interested to know how much return they are getting on the money they have invested in your business. To find out, divide the Net Income by the Shareholder’s Equity.

    Return on Equity = Net Income / Shareholder’s Equity

    The higher the number, the better are the returns that the shareholders are getting.

  1. Return on Assets:

    Companies also need to calculate the returns they are generating with regard to the assets they have. Once again, take the Net Income, but this time, divide it with Total Assets.

    Return on Assets = Net Income / Total Assets

    If the number is high, it indicates that your assets are being well utilized. If not, then it means that you need to change the way your resources are being put to work.

  1. Quick Ratio:

    Liquidity is a permanent problem for all companies, big or small, successful or unsuccessful. In a situation where cash is required urgently, whether assets can be converted fast enough is an answer given by the Quick Ratio, which is calculated by subtracting Inventories from Current Assets and dividing the remained by Current Liabilities.

    Quick Ratio = (Current Assets – Inventories) / Current Liabilities

    Another similar measure that excludes inventories from the equation is Current Ratio.

    Current Ratio = (Current Assets / Current Liabilities)

    The inclusion of inventories in Current Assets takes into account that these can be utilized to generate cash in the short term.

  1. Receivables Collection Period:

    Liquidity can also be a problem if the customers do not pay on time. This is why the company always has to calculate the Receivables Collection Period.

    Receivables Collection Period = (Days x Accounts Receivable) / Credit Sales

    This ratio enables them to find out how long it takes to receive payment from customers. The lower the number of days, the better it is for the company.

  1. Days Payable Outstanding:

    The business also has to keep track of how long it takes to pay creditors and vendors. This formula gives them that information.

    Days Payable Outstanding = Accounts Payable / Cost of Sales x Number of Days

    The ideal number varies from company to company. But the important factor is that this number is kept under check so that they are not penalized for late payments.

  1. Debt Equity Ratio:

    This is an important ratio that is calculated by dividing Total Liabilities with Shareholder’s Equity.

    Debt Equity Ratio = Total Liabilities / Shareholder’s Equity

    An important problem that companies face is how to finance their business. Some take the equities route, others take the debt route, but most companies use a judicious mix of the two. Different analysts have their own ideas on what the ideal number should be. But there isn’t one. The numbers differ from industry to industry and company to company. The best ratio is one that the company can handle. Some companies are aggressive and do not mind taking on a lot of liabilities to finance their operations, since they are confident of the returns they will get. But the most important factor in this equation is that the finance manager should be prepared for all scenarios and not realize one day that the business has taken on a burden it cannot handle.

  1. Inventory Turnover Ratio:

    The inventory turnover ratio can be calculated with this formula:

    Inventory Turnover Ratio = 365/ (Cost of Goods sold/Average inventory)

    If there is high inventory turnover and low sales, action can be taken to boost the sales numbers.

Calculating ratios is not a onetime activity. It has to be done at periodic intervals. Trends should be charted so that the finance team knows if the company is faring better or worse.

Ratios are also a great way of pre-empting a crisis. For example, if Gross Profit or Net Profit is dropping over a period of time, then action can be taken quickly to cut expenses and increase revenue.

The CEO might ask the CFO about the best way to fund the expansion strategy of the company. The CFO can look at the Debt-Equity ratio and judge whether to go for an IPO or ask a consortium of banks for loans.

Financial ratios can be put to use in many different ways. The trick lies in understanding what information you seek and how you intend to use this information.

Also Read Related Articles:

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1 5 Essential Roles of a Financial Control Team
2 Critical Warning Signs in Financial Statements
3 Importance of Financial Planning for Organizations

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