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How to Determine Your Business Success with Financial Ratio

Guest post by: Betty Penny

Article Overview: If you’ve ever wondered how well your business is doing - truly doing - one way to clear up the mystery is to use financial ratios. Financial ratios are used by accountants and bankers to evaluate everything from your current income ratio, to debts, to inventory, and even your return on sales or capital investments. A lower ratio means a more severe problem. Another important assessment step in financial ratios is estimating your debt equity ratio. The debt equity ratio compares debt and equity and the two types of capitalization.

How to Determine Your Business Success with Financial Ratio

Confucius once said, “A man is measured by the quality of his life”. This is probably true, but how does one measure the quality of one’s business life? If you’ve ever wondered how well your business is doing — truly doing — one way to clear up the mystery is to use financial ratios. Financial ratios are used by accountants and bankers to evaluate everything from your current income ratio, to debts, to inventory, and even your return on sales or capital investments. A thorough investigation, with a bit of simple math, can help you determine not only how well your business is doing, but also how you can improve on performance and income.

The best place to begin with on financial ratios is to assess your current ratio level. The current ratio is a comparison between current assets and current liabilities. Current means within a year. Current assets are items such as bank balances, accounts receivable or property that can be turned into cash within a 12-month period. A current liability is any debt due to be paid within one year. A ratio of 2 to 1 or higher is a sign that the company knows how to manage their cash flow successfully. A ratio with the asset number lower than 2 is a sign of cash control problems. A lower ratio means a more severe problem. Take the following for example:

Current Assets 932,500 = 2.3 to 1 = good cash flow Current Liabilities $405,000

Another financial ratio is inventory turnover. The inventory turnover ratio measures the number of times the average level of inventory is sold. It is a great measurement to know how effectively the company controls their inventory. If the rate of the inventory is down, it is a pretty good indicator that inventory levels are too high and are not being adequately controlled. Here is an example-showing inventory turnover ratios:

Cost of Goods Sold $1,900,000 = 8.8 times = good inventory

Average Inventory $214,000

Another important assessment step in financial ratios is estimating your debt equity ratio. The debt equity ratio compares debt and equity and the two types of capitalization. The company may receive operating funds through investors or borrowing. The higher the portion of the total that is borrowed, the greater the cost of carrying the debt, as interest is also accrued on the loan. As the ratio of debt increases, future profits can be anticipated to decline. The ratio is calculated by dividing liabilities by tangible net worth, like so:

Liabilities $400,000 = 49.9%

Tangible Net Worth $800,500

It should be noted that tangible net worth is the total of assets less liabilities, excluding any intangible assets (such as goodwill).

Like a return on investment, businesses must also determine their return on sales. Based on the proportion of net sales represented by net profits, it can be calculated by dividing sales into profits, like so:

Net Profit $210,000 = 5.5%

Sales $3,850,000

Remember when calculating your return on investment that a distinction should be made between pre-tax and after-tax profits.

Finally, is the return on capital ratio. Similar to the return on sales ratio, it is calculated on the capital in the company rather than the sales. The value of capital should be the amount available at the beginning of the year and the net profits should be the total for the entire year. Below is an example:

Net Profit $210,000 = 26.8%

Tangible Net Worth $782,000

There you have it: five straightforward equations that can measure just how well your business is doing, both accurately and effectively. Simple equations that can help set your business on a journey of discovery and future opportunities. If Confucius were around today the saying might be, “A business is measured by the quality of its financial ratios.”

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Article Tags: business success, debt equity ratio, financial ratios, income ratio



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