Strategic decision-making in business relies on relevant information about the business. Business and industrial financial ratios provide a way for businesses to examine financial performance to make real-time decisions that optimize them for profitability.
The knowledge of financial ratios is beneficial to every entrepreneur that seeks growth and profitability; it’s an integral part of basic finance for entrepreneurs. This article discusses financial ratios entrepreneurs need to know.
Importance of Financial Ratios
Financial ratios are fundamental tools for many players in the finance world, including founders, startups, small and medium business owners, accountants, IT specialists, and business analysts. Here are some key benefits of people needing financial ratios to founders.
1. Comparisons
Financial ratios can help a company to know its position in the market. By comparing its business’s financial performance with competitors, founders can identify gaps. This discovery enables the company to take a strategic stand to optimize financial management and improve profitability.
2. Operational Efficiency
Especially for startups, inefficient use of assets puts the business at risk of death. Financial ratios reveal operational cost management to enable a company to achieve operational efficiency, which stresses lower costs for maximum profitability. Essentially, business owners can know how financial resources are utilized to eliminate unnecessary expenses.
3. Financial Forecasts
Financial statements show financial trends over a reporting period which can be a tool for effective performance forecasts. Financial ratios can also help businesses identify potential financial crises and take strategic actions ahead of time.
Key Financial Ratios
Financial ratios are crucial for determining a business’s financial health. Some key financial ratios for startups and companies at other stages include:
Leverage Ratios
Leverage ratios measure a company’s debt level relative to the business’s equity. A high liquidity ratio indicates a high risk of bankruptcy for a business. The two primary liquidity ratios include:
- Debt-to-equity ratio: compares assets (shareholders’ investments) to debts to determine the debt level of a business. The debt-to-equity ratio is derived from dividing total liabilities by shareholders’ equity.
- debt-to-asset ratio: compares equity to debt to reveal the percentage of a company’s assets financed using credit. The debt to asset ratio is calculated as total debt divided by total equity.
Liquidity Ratios
Liquidity ratios measure a business’s ability to pay its debt obligations and its margin of safety. The financial leverage ratio indicates a company’s ability to use its current assets to cover its current liabilities.
- Working capital ratio: measures a company’s ability to pay its debt obligations within twelve months. It is obtained by dividing current assets by current liabilities. It is used to determine whether a company qualifies for short-term loans.
- Cash ratio: indicates whether or not a company has sufficient cash to offset its current debt. The cash ratio is calculated as liquid assets divided by current liabilities.
Profitability Ratios
Profitability ratios measure a company’s overall profitability, taking both direct and indirect costs into account. A high ratio indicates a positive return.
- Return on equity: measures the profitability of equity funds invested in the company. Return on equity is calculated as profit after tax divided by net worth, where net worth = equity share capital + reserve and surplus.
- Earnings per share: measures of a publicly-traded company’s earnings per share of stock. Earnings per share are obtained by dividing net profit by the total number of common stocks. It is calculated quarterly or annually.
- Net profit: the amount of money in percentage a business earns over a given period after deducting operating cost, interest, and tax.
- Return on assets: shows the percentage of net earnings relative to the company’s total assets. The formula for ROA is Income from operations divided by average total assets.
Asset Management Ratios
Asset management ratios measure management efficiency by comparing operating expenses to net sales.
- Receivable turnover: measures the rate or speed at which credit is redeemed. It’s calculated as Net Annual Credit Sales / Average Accounts Receivable.
- Inventory turnover: measures the level of efficiency in inventory management. Inventory turnover = cost of goods sold / Average inventory.
Focus On What Matters
As an entrepreneur, it’s important to track your business’s financial performance, and that’s a primary reason to learn about financial ratios. Analyzing your business financial situation is easier when you use a cheat sheet that contains all the key financial ratios. Better still, reach out to accountero to help you manage your business finance professionally. With dashboards ‘built-for-founders,’ on the accountero platform, it’s easy to monitor your business growth. Talk to us to get started and let us help you excel on your entrepreneurial journey.