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Financial Ratios
 

Financial ratios are calculated directly from numbers on your financial statements. They make relationships in your business more understandable and are a simple way to evaluate what’s really going on in your books. They should be looked at and compared on a monthly basis; that way, you will spot the trends as they develop, not afterword. It will point out to you if you are doing something well and also if something is wrong. That way, you can take measures to fix it before it becomes a major problem.

Below are some of the key financials ratios that we believe are important for small business owners to know and track for their own business:

Current Ratio
What it is:

The current ratio is the standard measure of any business' financial health. It will tell you whether your business is able to meet its current obligations by measuring if it has enough assets to cover its liabilities. The standard current ratio for a healthy business is two, meaning it has twice as many assets as liabilities.

When to use it:

The current ratio should be part of your business' basic financial planning, meaning it should be tracked monthly or quarterly. By keeping a close eye on this figure, you will recognize if it begins to get out of line. This will allow you to take early action to prevent your business from ending up in a difficult position.

The formula:

Current assets divided by current liabilities.

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Debt Ratio
What it is:

The debt ratio is another important ratio in measuring any business’ financial health. It tells you how much your buisness is in debt, compared to your dollars in assets. The standard debt ratio for a healthy business should be 1 or less, meaning they have the same amount or less debt, compared to their assets.

When to use it:

The debt ratio should be tracked on a monthly basis. It is very important to have a healthy debt ratio, or else the business can suffer from high interest and principal payments, and it could even lead to insolvency or bankruptcy. It is also very hard to get a loan when the business has a high debt ratio.

The formula:

Total Debt/Total Assets

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Inventory Turnover Ratio
What it is:

This ratio tells how often a business' inventory turns over during the course of the year. Because inventories are the least liquid form of asset, a high inventory turnover ratio is generally positive. On the other hand, an unusually high ratio compared to the average for your industry could mean a business is losing sales because of inadequate stock on hand.

When to use it:

If your business has significant assets tied up in inventory, tracking your turnover is critical to successful financial planning. If inventory is turning too slowly, it could indicate that it may be hampering your cash flow. Because this ratio judges annual inventory turns, it is usually conducted once a year.

The formula:

Cost of goods sold divided by the average value of inventory.

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Average Collections Period
What it is:

This ratio will indicate how quickly your customers are paying their bills by revealing the average length of your collection period. Ideally, the average collections period will be less than your credit terms plus 15 days.

When to use it:

The speed at which bills are collected has a significant impact on a business' cash flow. Use this ratio to determine how long your company's money is being tied up in customer credit. If you allow different credit terms for different transactions - net plus 30 days for some customers, net plus 60 for others -calculate the average collection periods separately.

The formula:

Accounts receivable divided by (annual net credit sales divided by 365)

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Debt to Equity Ratio
What it is:

This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. A high debt to equity ratio could indicate that the company may be over-leveraged, and should look for ways to reduce its debt.

When to use it:

Equity and debt are two key figures on a financial statement, and lenders or investors often use the relationship of these two figures to evaluate risk. The ratio of your business' equity to its long-term debt provides a window into how strong its finances are. Equity will include goods and property your business owns, plus any claims it has against other entities. Debts will include both current and long-term liabilities.

The formula:

Total liabilities divided by total equity.

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Gross Profit Margin Ratio
What it is:

The gross profit margin ratio indicates how efficiently a business is using its materials and labor in the production process. It shows the percentage of net sales remaining after subtracting cost of goods sold. A high gross profit margin indicates that a business can make a reasonable profit on sales, as long as it keeps overhead costs in control.

When to use it:

This figure answers the question "Am I pricing my goods or services properly?" A low margin - especially in relation to industry norms - could indicate you are underpricing. A high margin could indicate overpricing if business is slow and profits are weak.

The formula:

Gross Profit divided by Total Sales.

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Return on Sales Ratio
What it is:

This ratio compares after tax profit to sales. It can help you determine if you are making enough of a return on your sales effort.

When to use it:

If your company is experiencing a cash flow crunch, it could be because its mark-up is not enough to cover expenses. Return on sales can help point this out, and allow you to adjust prices for an adequate profit. Also, be sure to look for trends in this figure. If it appears to be dropping over time, it could be a signal that you will soon be experiencing financial problems.

The formula:

Net profit divided by sales.

*Information was adapted from American Express website

 



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