Understanding The Common Business Financial Ratios

Analysing common financial ratios in your business provides you with insights and perspectives that enable you to better determine the actual performance of your business, be clear about its current condition and make better projections.

It is a way of gathering facts to inform your next moves, rather than forging ahead on the basis of assumptions.  Over time, these analyses become more and more valuable, providing an ever richer track record of your performance.  However, they also play a primary role in competitive analysis and industry benchmarking.

Often, small business owners are most concerned with basic ration formulas such as debt and liquidity ratios.

What is the liquidity ratio?

The value of a liquidity ratio is that it shows you how well you can cover your short-term debt with your current assets.

The formula is:  total current assets/total current liabilities

So, for example this can be applied as follows:
Company A currently has assets of $100,000/liabilities of $75,000, which gives them a liability ratio of 1.33.

It is common for businesses to strive for a ratio of 2.0 or more, but less can be tolerable.

This can be taken further, however, by businesses holding an inventory so that you can assess how well you can cover short-term liabilities with your current assets, but less your inventory.  The idea behind this is that you remove inventory because it is the portion of your current assets that is hardest to liquidate into cash quickly.

This formula is:  total current assets-minus inventory/total current liabilities.

The example of its application is Company A currently has assets of $100,000 minus $25,000 in inventory divided by the liabilities of $75,000, which gives them a ratio now of 1.0.

So Company A has $1.00 of current assets, disregarding inventory to cover each dollar of liability.  This ratio should always be equal to 1.0 or more.

What is debt ratio?

Debt ratio indicates your business’s capacity to borrow. Examples are the debt ratio and the debt-to-equity ratio.

  • The debt ratio which compares your debt to your assets reveals your reliance on borrowing to finance your operations.

The formula is:  total debt divided/total assets.

So, for example this can be applied as follows:
Company B currently has a total debt of $25,000/total assets of $200,000, which gives them a debt ratio  of 0.121.  This means Company B has 12.1 cents in debt for every dollar of total asset and this would be regarded as an safe ratio in any industry. You will find though that suitable debt ratios do fluctuate from industry to industry.

  • The debt-to-equity ratio compares your business’s indebtedness to its total equity.

The formula is: total debt/total equity (net worth).

In this example Company B has a total debt of $25,000 and a total equity of $25,000 and so the formula is applied like this: Total Debt $25,000/ Total Equity ($25,000) = 1.0.  So Company B has $1.00 of debt for every dollar of total equity. Once again this is an excellent debt-to-equity ratio of 1.0 in most industries, but variations can occur.

It pays for the small business owner to work with an accountant or business advisor to identify and use the financial ratios that would be most valuable for your business.  They can also advise you on how to use this intelligence in your goal-setting, planning and management.  When you know your ratios, you are empowered to compare them against competitors with enriches your understanding of your market position and leadership stance in your industry.

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