There are three main groups of ratios that all business owners can use in their business to gain a better insight about their business and take control of their company’s success: Liquidity, solvency and profitability.
3 Key Liquidity Ratios:
Current Ratio – Calculated by taking your Current Assets and dividing them by your Current Liabilities. Both of these amounts are found on your Balance Sheet. This provides you with a number that demonstrates how much more current assets you have than current debt. Ideally you want it to be two to three times the amount so that you can be able to meet your current operational expenses and debt.
Accounts Receivable Turnover – Calculated by taking your Net Sales and dividing them by your average Accounts Receivable. Sales are found on your Profit & Loss and Accounts Receivable will be found on your Balance Sheet.This ratio enables you to see how efficient you are at collecting your Accounts Receivable. It doesn’t matter how much you sell if you don’t collect on your receivables. Managing accounts receivables is one of the top operational improvements you can implement in your organization to boost your bottom line and your cash flow.
Total Asset Turnover – Calculated by taking your Net Sales and dividing them by your average Total Assets. Sales are found on your Profit & Loss and Assets are found on your Balance Sheet. This demonstrates how well you are at utilizing your assets to generate revenue. The only reason we spend money on assets is to provide a return to the company. Having assets that do not contribute to that goal are will cause this ratio to decrease.
3 Key Solvency Ratios
Debt Ratio – Total Liabilities divided by Total Assets. This provides you the percentage of your assets that are financed by debt. Your assets and liabilities can both be found on your Balance Sheet and includes both current and long-term items.
Equity Ratio – Total Equity divided by Total Assets. Your Equity Ratio represents the percentage of your assets that are financed by the owner’s equity in the business. Equity and Asset amounts are both found on your Balance Sheet.
Times Interest Earned – Earnings before Interest and Taxes (EBIT) divided by Interest Expense. This provides you the protection rate you have in meeting your interest obligations. Earnings before Interest & Taxes as well as your Interest Expense are found on your Profit & Loss Statement.
3 Key Profitability Ratios
Profit Margin Ratio – Net Profit divided by Net Sales. This calculation provides you with the net profit in each sales dollar. What is left after all your direct and indirect costs to cover loan principal payments, invest in future business growth and give the owners a return on their investment?
Gross Margin Ratio – Gross Profit divided by Net Sales. This provides the gross profit in each sales dollar; which equates to the amount left after just the direct costs are taken from the revenue. Indirect costs are then subtracted from this figure to achieve the Net Profit for the business.
Return on Total Assets – Net Profit divided by Average Total Assets. You can calculate the average total assets by summing your begining year Total Asset balance and your end of the year balance and dividing by two. This provides the overall profitability of your assets. The only reason we should purchase assets is to generate revenue, directly or indirectly. So if you accumulate a lot of assets that don’t bring a return of revenue, then they may not be wise investments for the business.
Measuring solvency, liquidity, and profitability are key to understanding the many facets of running a business. Utilize these ratios and the comparison of your business with your industry to see where your business excels and where it needs attention.
Not sure how you compare to your competition? Check out your industry information and see how your company stacks up!
To find industry statistics, you can:
- Contact your industry association
- Research via the Internet
- Utilize your local business library
Each industry’s standards vary so it is wise to not just take the numbers by itself. They are part of the bigger financial analysis process you will want to do monthly. Analyzing your Profit & Loss and Balance Sheet monthly reports provides insight into your company that is key to ongoing success.
Pam Morin, Author of Out of the Red and Boost Your Bottom Line, Speaker, Certified Management Accountant, Entrepreneur, Advanced Certified QuickBooks ProAdvisor, President of RPPC, Inc. www.rppc.net, firstname.lastname@example.org, 816-304-4398.