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How to use financial ratios to improve your business

3-minute read

Financial ratios offer entrepreneurs a way to evaluate their company’s performance and compare it other similar businesses in their industry.

Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This allows you to follow your company’s performance over time and uncover signs of trouble.

Here are some key financial ratios to measure the financial health of your 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 bankers 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 sufficient cash flow to meet short-term obligations, take advantage of opportunities and attract favourable credit terms. A ratio of 1 or greater is considered acceptable for most businesses.

2. Cash ratio = Liquid assets / Current liabilities

Indicates a company's ability to pay immediate creditor demands, using its most liquid assets. It gives a snapshot of a business's ability to repay current obligations as it excludes inventory and prepaid items for which cash cannot be obtained immediately.

Profitability ratios

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

Shows the net income generated by each dollar of sales. It measures the percentage of sales revenue retained by the company after operating 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 dollar of equity. 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 accounts receivable

A higher turnover rate generally indicates less money is tied up in accounts receivable 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 accounts payable / Total amount of purchases on credit

Measures the average number of days it you are taking to pay suppliers.

4. Inventory turnover = Cost of goods sold / Average inventory

Measures the efficiency of assets in generating profit.

Try BDC’s free financial ratio calculators to assess the performance of your business.

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