Business owners uses financial statements to assess the condition and performance of their business. They do so in order to improve their sales, processes, budgets and/or forecasts. Oftentimes, they use financial statements as basis of their business decisions.
A financial statement provides detailed report, shown in numbers. Typically, a company has the following financial statements prepared every month:
- Statement of Financial Condition (also known as Balance Sheet);
- Statement of Financial Performance (also known as Income Statement), and;
- Statement of Cash Flow (also known as Cash Flow Statement).
These financial statements are basic requirements in preparation of financial ratios which I will be sharing in this article.
What is a Financial Ratio?
Financial ratios presents the financial data of the company using ratio or percentage. Financial ratio is computed by comparing two data with one another. Normally, the financial data comes from the financial statements of comparative years. Example of comparison is analyzing current year financial data, and then comparing it to the previous year data. Another is using forecast or budget as comparison.
The financial ratios simplify and makes it easier to assess a business financial data without the need of looking at the very detailed numbers. Financial ratios are often used by people who don’t like, or doesn’t have time, to look at the detailed numbers.
Even though the ability to read and interpret financial ratios is a crucial business management skill, however, many business owners, especially those who owns a small and medium enterprise, often do not understand or doesn’t give the time to understand these financial ratios.
In this article, I will share with you the basic financial ratios every business owner should know and assess in the business. I will try to explain to you why ratios can help you in your business decision.
Profitability Ratio
The first and most popular ratio to business owners is the profitability ratio.
Profitability ratio is computed and used to determine if the company is able to derive profit and return on their invested resources in the business. Sample of resources include assets and capital.
The goal in profitability ratio is to assess if your business is over or underspending, as well as if it’s able to generate sales given the amount of resources invested to it. Profitability ratio can help you assess if you are over or under utilizing your total assets or investments.
Below are basic types of profitability ratio:
- Gross Profit Margin – it is computed by dividing the gross profit over total sales. Gross Profit Margin is used to compute the profit from the mark up on the cost of the product or service sold.
- Net Profit Margin – it is computed by dividing the net profit over total sales. Net Profit Margin is used to compute the percentage of overall profit of the business after deducting all costs or expenses.
- Return on Assets (ROA) – it is computed by dividing the net income (or profit) over total assets. Return on Assets (ROA) helps in assessing if the total investment in asset was able to produce profit for the company. It is used to compute the percentage of income produced by the total assets invested. Additionally, using ROA, you can determine how long it is for the business to recover the total investment in assets.
Liquidity Ratio
The second important financial ratio is liquidity ratio. Liquidity ratio shows if the company can pay its currently due debts, and still have enough resources to sustain the current operation. The goal of liquidity ratio is to measure and check if the company will not be having cash problem due to the total expenses, and currently due obligations.
Below are basic types of liquidity ratio:
- Current Ratio – it is computed by dividing the total current assets over total current liabilities.
Current assets mean company resources which will be used within one (1) year. Example: cash, current receivables, inventory, prepayments and other short-term assets. Current liabilities, on the other hand, are liabilities or debts due for payment within the year. Example: accounts payable, short-term liabilities, accrued expenses, government payables, etc.
The ideal current ratio is 2. It means for every 1 current liability, there should be 2 current assets. The difference of 1 is for the current operation.
- Quick Ratio – it is computed by dividing the total current assets less total cost of inventory over total current liabilities. The ideal quick ratio is 1.5 which means for every 1 current liability there should be 1.5 quick assets. The difference of 0.50 is for the current operation.
Leverage Ratio
The third but not least basic financial ratio is leverage ratio. Leverage ratio shows the ability of the company to get loan and investments from third parties, aside from the owners of the business. The goal of leverage ratio is to assess if the business can get sources of funds from outside of the company and yet keeping the level of control (% of ownership) in the business.
Below are basic types of leverage ratio:
- Debt Ratio – it is computed by dividing the total liabilities over total assets. The result will show the percentage of debts of the company. In simple term, it is the percentage of share of the creditors over the company’s total assets. Conservatively, this should be kept below 50%. Anything above it is an indication of the company’s aggressive strategy since the company is giving away 50% of the company to the creditors. It’s like you’re working on the business for the creditors.
- Equity Ratio – it is computed by dividing the total equities over total assets. The result will show the percentage of total owner’s equity in the company. In simple term, it is the percentage of share of the stockholders over the company’s total assets. Conservatively, this should be kept more than 50%. Anything below is an indication of the business aggressive strategy since their keeping less share in the company.
To learn more about this you may attend our training on Financial Statement Analysis.
These ratios are automatically prepared and computed in MPM Insight, our very own financial reporting tool available to our clients for our Outsourced Accounting Services.
