Financial ratios are a major factor in business, but far from the most glamorous part of business ownership. Unless you have a background in accounting, many might not even come to mind.
Their importance, though, can mean the difference between having profitability and financial leverage and not. Where, then, do you start?
We’ll begin by finding the most important financial ratios. With the right tools and understanding, these ratios will become a vital part of your business.
Breaking Down the Most Important Financial Ratios
Even without a degree in finance, financial ratios are not complex things to understand. Ensuring complete accuracy in them, though, is an important matter as well.
To help, there are potent tools like the ratio calculator. This can help break down numbers and ratios to get a clearer image of what you are working with.
The following are the 5 ratio categories that any business owner should understand.
1. Liquidity Ratios
Liquidity ratios center around how well a business can liquidate assets to pay off financial requirements. This can showcase how flexible a business can be with their spending.
This includes the current ratio, which is current assets over current liabilities. There is also the quick ratio, which is a more in-depth sum of cash, cash equivalents, short-term investments, and accounts receivable divided by current liabilities.
2. Profitability Ratios
Profitability ratios look at the long term sustainability of a business. This is important for investors to gauge how positive investing in this business will be.
The ratios include the operating profit margin, which takes operating profit and divides it by net revenue. You can also find the net profit margin by taking net income and dividing it by net revenue.
3. Cash Flow and Efficiency Ratios
Cash flow and efficiency ratios look at how healthy the current business is. This can help both business operators and investors determine how well the current income can turn into future investments.
The operating cash flow to sales ratio takes operating cash flow over net revenue and shows how the cash flow can make future sales.
4. Collection Ratios
Collection ratios are most important for small businesses. They refer to how well you can collect on owed credit. This can be important for dealing with lenders.
These ratios include the accounts receivable turnover ratio. This works by taking net credit sales and dividing it by average accounts receivable.
The day sales outstanding ratio, which is the number of days in the year over accounts receivable turnover, can then tell you how long your clients take to pay you back.
5. Leverage Ratios
Leverage ratios look at how much your company depends on borrowing for daily operations. This is the biggest ratio for bankers and investors as too heavy on borrowing can mean poor profits.
The debt to equity ratio, which is debt over the owner’s equity, gives a good look at the company’s investor supplied capitol.
The fixed to worth ratio, which is net fixed assets over tangible net worth, showcases the owner’s investment in fixed assets. It helps to showcase the stability of the company to investors.
Building a Better Business with Better Tools
These are the basics of 5 of the most important financial ratios. While there is still much to learn, understanding these elements will provide a lot of clarity toward future business success.
Navigating toward that success takes a lot of quality tools and information. In addition to the ratio calculator, there are many more tools here for SEO and marketing content. Continue on your journey toward a stronger business with our other articles today!