Analyse And Improve Your Business With Financial Ratios

Posted in Business Growth, Business Tips, Good Advice

Ratios measure the relationship between two or more figures in the financial statements. They are used most effectively when results over a number of periods or years are compared. You will see trends or inconsistencies that might need to be addressed.

Ratios can indicate whether a business is sufficiently profitable or whether cash flow is adequate to meet financial obligations.

The following are the main financial ratios to measure the financial health of a business.

Leverage ratios

1. Debt-to-equity ratio • Total liabilities/Shareholders’ equity

Measures how much debt a business is carrying as compared to the amount invested by its owners. This indicator is closely watched by banks as a measure of a business’s capacity to repay its debts.

2. Debt-to-asset ratio • Total liabilities/Total assets

Shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness.

Liquidity ratios

1. Working capital ratio • Current assets/Current liabilities

Indicates whether a business has enough cash flow to meet short-term obligations. A ratio of 1 or greater is considered acceptable for most businesses.

2. Cash ratio • Current assets/Current liabilities

Indicates a company’s ability to pay immediate liabilities using its most liquid assets. Shows a business’s ability to repay  current obligations as it excludes stock and prepaid items for which cash cannot be obtained quickly.

Profitability ratios

1. Net profit margin • After tax net profit/Net sales

Shows the net income generated by each € of sales. It measures the percentage of sales revenue retained by the company after expenses, interest and taxes have been paid.

2. Return on shareholders’ equity • Net income/Shareholders’ equity

Indicates the amount of after-tax profit generated for each € of equity. It is a measure of the rate of return the shareholders received on their investment.

3. Coverage ratio • Profit before interest and taxes/Annual interest and bank charges

Measures a business’s capacity to generate adequate income to repay interest on its debt.

4. Return on total assets • Income from operations/Average total assets

Measures the efficiency of assets in generating profit.

Operations ratios

1. Accounts receivable turnover • Net sales/Average debtors

A higher turnover rate generally indicates less money is tied up in debtors because customers are paying quickly.

2. Average collection period • Days in the period X Average accounts receivable /Total amount of net credit sales in period.

Indicates the amount of time customers are taking to pay their bills.

3. Average days payable • Days in the period X Average creditors/Total amount of purchases on credit

Indicates the average number of days a business takes to pay suppliers.

4. Stock turnover • Cost of goods sold/Average stock

Indicates the amount of times stock has been turned over during the year.

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