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Want a Healthy Balance Sheet? Start Using These Financial Ratios

Financial ratios can show you alot of things about your business; whether you’re profitable enough, or if you have enough cash flow to meet certain obligations such as paying dividends or taking on a new loan to invest in assets for your business. That kind of information is crucial to helping you make informed business decisions and act proactively.


In this blog I will provide the four main categories of financial ratios and an example of the most widely used financial ratio in each category and how to use them to boost your business.


Financial ratios offer entrepreneurs a way to evaluate their company’s performance and compare it other similar businesses in their industry. In the simplest definition ratios measure the relationship between two or more components of financial statements.

They are used most effectively when comparing results over several reporting periods such as months or years. This allows you to follow your company’s performance over time and identify signs of potential trouble.


Here are the key financial ratios to measure the financial health of your business.


Leverage Ratios

1. Debt-to-equity ratio = Total liabilities / Shareholders' equity

Measures how much debt a business is carrying as compared to the amount invested by its owners plus the amount of net income retained in the company as investment back in the business. This indicator is widely used by bankers & lenders as a measure of a business’s capacity to repay its debts.


2. Debt-to-asset ratio = Total liabilities / Total assets

Shows the percentage of a company’s assets financed by creditors (short term & long term debt). A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness.


Liquidity Ratios

1. Working capital ratio = Current assets / Current liabilities

Indicates whether a business has sufficient cash on hand to meet short-term obligations, are the current assets (think cash, inventory & any other current asset that can be converted to cash within 12 months) greater than the current liabilities (the bills & debt obligations that the business will have to pay within 12 months). You want your business to have a ratio of greater than 1 otherwise you may not have enough cash to pay for ongoing daily business needs such as inventory and office expenses. A ratio of 1 or greater is considered a requirement for most businesses.


2. Cash ratio = Liquid assets / Current liabilities

This ratio indicates a company's ability to pay immediate creditor demands, using its most liquid asset, cash. It gives a snapshot of a business's ability to repay current obligations as it excludes inventory and prepaid items for which cash cannot be obtained immediately. For more information on the importance of free chasflow to your business read our blog on How to Manage Your Small Business Cashflow



Profitability Ratios

1. Net profit margin = After tax net profit / Net sales

Shows the net income generated by each dollar of sales. It measures the percentage of sales revenue retained by the company after operating expenses, interest and taxes have been paid.


2. Return on shareholders’ equity = Net income / Shareholders' equity

Indicates the amount of after-tax profit generated for each dollar of equity. A measure of the rate of return the shareholders received on their investment.


3. Coverage ratio = Profit before interest and taxes / Annual interest and bank charges

Measures a business's capacity to generate adequate income to repay interest on its debt. Also known as DSCR Debt service Coverage Ratio (profit before interest and taxes / debt servicing obligations) your Banker/Lender will use this ratio to determine if there is sufficient cushion in your ability to repay debt given a decrease in profits. Typically a lender will want to see a DSCR of 1.20x or greater. That means that they want the business to have 20% or more cushion in available profits to service annual debt obligations (principal & interest).


4. Return on total assets = Earnings before Interest & Taxes (EBIT) / Average total assets

Measures the efficiency of assets in generating profit. This ratio will help you determine how your business generates its earnings and how effective you are at using your assets to generate income. EBIT is used instead of net profit to keep the metric focused on operating earnings without the influence of tax or financing differences when compared to similar companies.



Operations ratios


1. Accounts receivable turnover = Net sales / Average accounts receivable

The accounts receivable turnover ratio indicates how effectively a business collects credit from its debtors. It calculates how frequently a company manages its average accounts receivable over a specified period.



A high receivables turnover ratio can indicate that a company's collection of accounts receivable is efficient and that it has a high proportion of quality customers who pay their debts quickly. A high receivables turnover ratio might also indicate that a company operates on a cash basis.


2. Average collection period = Days in the period X Average accounts

receivable / Total amount of net credit sales in period

The average collection period is the average number of days it takes a business to collect and convert its accounts receivable into cash. It is one of six main calculations used to determine short-term liquidity, that is, the ability of a company to pay its bills (current liabilities) as they come due.


3. Average days payable = Days in the period X Average accounts payable /

Total amount of purchases on credit

Measures the average number of days it you are taking to pay suppliers.


4. Inventory turnover = Cost of goods sold / Average inventory

Measures the efficiency of assets in generating profit.




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