When it comes to your small business’ finances, you need every tool you can get your hands on to be successful. Having a good handle on business financial ratios and financial ratio analysis will help you do just that.
What are business ratios? They are tools that help you to evaluate what the performance is of your business.
Business financial ratios can help you find problem areas in your business so that they can be fixed before they are out of control. They are mathematical and numerical relationships between the different items in a company’s financial statements.
Business ratios are also fairly easy to learn and calculate – but you also need to have some knowledge about your company’s financial statements.
There are a lot of different business financial ratios, but there are a few that are very important for small business owners to know.
Liquidity ratios: These ratios are used to measure the ability of a company or a business to meet the obligations that they have for the short-term.
The current ratio is one of the major business ratios in this category.
Current ratio: Total of a company’s current assets/Total of a company’s current liabilities.
When a company has a high current ratio, it means that the business is able to meet the obligations that they have for the short term. When the ratio is lower, it means that the company won’t be able to meet the company’s obligations for the short term.
Even though it’s not a good financial sign, it doesn’t automatically mean that the company is going to go bankrupt.
There are a lot of ways that a company may be able to get financing so that it’s able to meet the short-term obligations.
Leverage ratio: The leverage ratio will measure the degree a business is being financed by any kind of debt.
The major ratio, which is in this category, shows the amount of debt as compared to the company’s equity.
Debt to Equity ratio: Total long term debt/ Amount of equity the business has.
When the ratio is higher, it means that the business has financed the growth of the company with debt.
The problem with this is that the costs of the interest of the debt aren’t covered by the return that the company will see with its growth.
Activity ratios: The activity ration shows how well a company is using the resources that is has.
The ratio that shows this is known as the inventory turnover ratio.
Inventory turnover ratio: A company’s sales/a company’s inventory.
The ratio that is for a specific period will show how often the inventory is being sold and then replaced.
When there is a low ratio, it means that there haven’t been a lot of sales during that period. When there is a high ratio, it shows a lot of sales and that there may be too little inventory to meet the demands of customers.
Financial ratio analysis and business ratios are important to know, so that you know how your small business is doing – and so that you know what adjustments are necessary to improve your overall performance.