Financial Ratios

Once you have acquired the habit of regular bookkeeping and you have learned to navigate a set of financial statements you have a lot of information that can help you better manage your business.

However, if you really want to take your management to a new level, it might be time for some ratio analysis. A financial ratio is a simple mathematical comparison of two or more entries from a company’s financial statements. Business owners and managers use ratios to chart a company’s progress, uncover trends and point to potential problem areas. Bankers and investors look at a company’s ratios when they are trying to evaluate risk and to decide if they want to lend you money or invest in your company.

In this brief we introduce four types of ratios: liquidity, profitability, leverage, and turnover.

Liquidity Ratios

Liquidity ratios measure how well a business is able to meet its short-term obligations as they fall due from available cash. In other words, can you pay the bills as they come due without having to borrow money or sell assets?

The current ratio compares current assets to current liabilities. This ratio is particularly important if you are thinking of borrowing money or getting credit from one of your suppliers. Potential creditors use this ratio to measure a company’s liquidity or ability to pay off short-term debts. Though acceptable ratios may vary from industry to industry, a current ratio of 2.0 is considered a good rule of thumb. The formula for the current ratio is:

Current ratio = Current assets divided by current liabilities

The quick ratio, sometimes called the acid test ratio, is similar to the current ratio, but is considered a more reliable indicator of a company’s ability to meet its short-term financial obligations. Because inventory can sometimes be difficult to liquidate, this ratio deducts inventory from your assets before computing the ratio. Potential creditors like to use this ratio because it reveals a company’s ability to pay off under the worst possible conditions.

Profitability ratios demonstrate whether the business is making any money and whether the level of profitability is large enough to justify capital investments.

The debt to assets ratio reveals the extent to which a company is financed with debt. Creditors look at this ratio when they are trying to decide what the chances are you won’t be able to make good on your business loans and obligations. A healthy company has a good balance between assets provided through debt and assets provided by the company’s owners. As you might guess, creditors like this number to be low. The lower it is, the greater the chance your company will be able to ride out rough times.

Inventory turnover ratio tells how often a business’ inventory turns over during the course of the year. Because inventories are the least liquid form of asset, a high inventory turnover ratio is generally positive. On the other hand, an unusually high ratio compared to the average for your industry could mean a business is losing sales because of inadequate stock on hand.

If your business has significant assets tied up in inventory, tracking your turnover is critical to successful financial planning. If inventory is turning too slowly, it could indicate that it may be hampering your cash flow. Because this ratio judges annual inventory turns, it is usually conducted once a year.

Payables turnover tells how quickly you are paying your bills. The payables turnover ratio reveals how often your payables turn over during the year. A high ratio means a relatively short time between purchase of goods and services and payment for them. A low ratio may be a sign that the company has chronic cash shortages.

Receivables turnover indicates how quickly your customers are paying you. The greater the number of times your receivables turn over during the year, the shorter the time between sales and cash collection. If this number is low compared to your industry average, it may mean your payment terms are too lenient or that you aren’t doing a good enough job on collections.

Ratios provide insight into every financial element in your company, from its profitability to the effectiveness of your accounts receivable department. When you compare today’s ratios to last year’s or a compilation of several years’ records, it can help you chart your progress and plan for the future. Once compiled, you can also use ratios to compare your company’s performance with others within your industry.

Prepared by Mary Peabody, UVM Extension for eXtension