18. Feb 2020 |

Financial Ratios: How to Measure Your Business’ Health

When you need to measure your business’ health, you need to make sure that you have all the correct information to hand. Financial ratios can help with this as they help you to make comparisons between various aspects of your business’ performance. However, it’s not always clear what financial ratios are and how they work. This article will serve as a brief guide to financial ratios, shedding a bit of light on the subject.

financial ratios
Financial ratios can help you determine how well your business is performing and where improvements can be made. (© pixabay.com)

What are Financial Ratios?

Ratios are used to compare specific parts of your business. They can help you to quickly see how they can be improved. In addition to this, the ratios can help you determine how well the business is performing in a specific industry or part of the country.

Financial ratios tend to offer basic information that can show if you have too much inventory or you’ve accumulated a lot of debt, for example. Ratios such as these and others can also help a prospective lender to determine the health and stability of your business. They will be able to do this by viewing your balance sheet.

Some lenders such as the bank will insist that your ratios are a part of your loan agreement. For example, they may insist that you keep your assets at a specific percentage above your liabilities. Financial ratios aren’t just useful when you’re applying for a loan. They can also help you to keep on top of any trends that are changing within the business.

What are the Major Categories of Ratios?

The major categories of ratios are:

  • Liquidity
  • Efficiency
  • Profitability
  • Leverage

Liquidity Ratios

Liquidity ratios measure the amount of cash and asets that can easily be converted. They help to provide a basic overview of the business’ financial health. It also shows how you can generate money to meet some of your short-term financial commitments. When you divide your assets by your liabilities you will have your working capital. Doing this will also show how easily you can get quick access to cash.

Ideally, you will have a ration of 1.0 or more. However, this ratio can depend on the industry you work in. If you have a low ratio you might not be able to meet your obligations. However, if you can pay off your liabilities you could improve your ratio.

If your ratio is high, it could mean that you’re failing to utilise your capital. You could, therefore, invest some of that capital in any of your projects that help to drive growth.

Efficiency ratios

These tend to be measured in 3 to 5 year periods. Efficiency ratios give you more insight into some areas of your business such as operational results, cash flow, and collections.

When it comes to inventory turnover, it will analyse how long the inventory has been sitting on the shelves or in the warehouse. If you’re reliant on your inventory, the longer your products sit in the warehouse, the more they will cost you.

Profitability ratios

Profitability ratios help you to evaluate your business’ financial viability. They are also there to help you compare your business with other similar businesses in the same industry. This ratio can also help you to spot trends in the company. You can do this if you compare ratios over a few years.

Your net profit margin will show you how much the business makes each year, relative to the sales. This can help you to take on some new opportunities and markets.

Leverage ratios

Leverage ratios provide you with an indication of the business’ long-term solvency. It can also help you to understand how you’re using your long-term debt to support the business.

Other leverage ratios to consider are the debt to equity ratios and debt to asset ratios. This will show any banks how well you can pay back any debt. It will also indicate whether you can take on any additional debt.

How They Help to Analyse the Financial Health of Your Business

As mentioned above, financial ratios can offer you basic information that can indicate if you have too much inventory or debt, for instance. Such ratios can help a bank determine the health and stability of your business via your balance sheet. In addition to this, if you have a few year’s worth of financial ratios to hand, you can make comparisons. In this respect, you can determine how well your business is performing and where improvements can be made.

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