Financial Ratios
As a business owner financial data is something you have become all too familiar with. Every month you take the necessary steps to ensure your financial data is current and accurate. First, you enter the data entry into your business’ accounting system. Then you have your accountant review the books. Your accountant performs the closing process and prepares a set of financial reports, or financial statements. You take the time to complete these steps because having accurate books is not only important but necessary. However, are you utilizing your financial data to better your business? This is where financial ratios come into play. But what are financial ratios, and why are they important?
What are Financial Ratios?
Financial ratios measure quantitative data from a business’ financial statements. The calculations for financial ratios come specifically from the balance sheet, income statement, and statement of cash flows. Comparing the ratios to industry averages and standards, and internal trends is beneficial. In doing this, it shows insight into a business’ performance, profitability, and financial health. In lament terms, financial ratios turn your business’ data into information that helps you manage your business better.
Financial Ratio Categories
There are five major categories of financial ratios. They are:
- Liquidity Ratios
- Activity Ratios
- Leverage Ratios
- Profitability Ratios
- Market Value Ratios
Liquidity ratios measure the ability of a business to pay off its short-term debt. The ratios help to determine if a business can use its current assets to cover its current liabilities. Common liquidity ratios are the current ratio, quick ratio, and cash ratio.
Activity ratios measure how efficiently a business is using and managing its resources to generate revenue. Often, these ratios are known as efficiency ratios. They are useful for comparing a business’ performance trending over time. Common activity ratios are accounts receivable turnover ratio, total asset turnover ratio, and days payable outstanding.
The next category of financial ratios is leverage ratios, also known as solvency ratios. These ratios measure how much debt a business uses to fund its operations. Common leverage ratios include the debt ratio, debt-equity ratio, and interest coverage ratio.
Profitability ratios measure a business’ ability to create earnings relative to its sales, operations, balance sheet assets, or shareholder’s equity. With these ratios, the higher the ratio result, the better. Examples of profitability ratios are gross profit margin, operating margin ratio, return on investments ratio, and return on asset ratio.
The last category is market value ratios. These ratios measure and analyze the current share price of a publicly held business’ stock. Examples of these ratios include earnings per share ratio, price earnings ratio, and book value per share ratio.
Why are Financial Ratios Important?
Financial ratios are useful tools for both internal and external users of a business. These ratios provide important information about a business’ performance. They help evaluate a business’ financial health. Also, ratios provide understanding of how a business is performing in comparison to its competitors. For example, management can use them to determine strengths and weaknesses of the business. Allowing for improvements to areas of weakness. As well as capitalizing on areas the business thrives in.
Financial ratios provide businesses with tools to assist in decision making. This ultimately helps a business achieve its goals. Our team is here to help if you need assistance with financial ratios!
Contributed by Elizabeth Partlow