Financial Ratios 101: What Business Owners Need To Know

The financial health and sustainability of your business are critical factors in determining the long-term viability of your company. The good news is that there are several financial ratios you can use to evaluate the health of your business.

These statistical indicators provide insight into how effectively your company uses its assets, how liquid its operating cash is, and other key performance indicators (KPIs) that indicate whether your business is operating efficiently or if it needs to make some tweaks to increase profitability and decrease risk.

Many people struggle with balancing their checkbooks, managing their personal finances, or understanding their business’s financial statements of their business? This can be challenging for anyone. That’s where financial ratios come in.

What Are Financial Ratios?

A financial ratio compares two financial items: cash flow and debt. It provides a snapshot of the financial health of a business at a single point in time, as well as how it has changed over time.

Financial ratios can be used to evaluate a company’s performance and business risk and to help investors understand the strength or weakness of a company’s financial position. Each ratio provides insight into a specific business function where rising or declining ratios indicate areas of weakness or strength, so you’ll want to monitor these ratios over time to look for trends.

How To Calculate Financial Ratios

There are several different methods for calculating ratios. The most common approach is to use the average numbers from your latest fiscal year, while other methods use the most recent month’s data.

Calculating ratios from the latest fiscal quarter is a more exact approach since the fiscal year data is typically two months old. All ratios are calculated as a percentage. Once you have the figures, you can plug them into a calculator or use online financial ratio calculators to find the results.

Here are a few examples of financial ratios you should look into.

1. Profit Margin

This ratio is the difference between revenue and the total cost of goods sold. The profit margin is the profit earned on each dollar of sales. A high-profit margin shows that the company generates a large profit on each product sold. A low margin indicates that the company only receives a small profit per item sold.

2. Debt to Equity Ratio

This ratio shows the relationship between your total debt and your total equity. The debt to equity ratio indicates how heavily you’re borrowing compared to how much equity you have in your company. It’s a good indicator of your company’s financial health and ability to repay loans.

3. Net Income to Total Assets Ratio

This ratio shows how much profit is generated by each dollar of assets. It is sometimes referred to as the return on assets ratio and indicates how effectively assets are being used to generate profit. A ratio below 1.00 indicates that your company is not generating enough profit with its assets. 

In Conclusion

Ratio analysis reveals insights about your business that aren’t readily available from other financial reporting methods. These ratios also provide evidence to lenders or investors if you need capital to grow or refinance. Hopefully, the information listed above, including the few examples of financial ratios, can help you determine whether a company is stable and growing at an acceptable rate or if it needs to make changes to its financial strategy.

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