It is crucial to understand financial ratios if you’re running a company. Doing so can help ensure your business is operating smoothly. Starting with the current ratio can help you determine how much of your assets you actually own.
1. Current Ratio
Using the current ratio indicates the present financial strength of your business. It shows how much bigger your current assets are compared to liabilities. It’s derived by using the following formula:
Current Ratio = Total Current Assets / Total Current Liabilities
For example, if you currently have $1500 cash, $8000 in your checking account and $10,500 in inventory, your total current assets equal $20,000. If you are borrowing $10,000 from the bank to operate your business, the current ratio would be:
$20,000/$10,000 = 2 to 1
Having a 2 to 1 ratio is a healthy number for your business. It indicates you have double the number of assets compared to liabilities. If the current ratio of your business equals a 1 to 1 ratio, it would not be as healthy. This ratio indicates you have several business loans, which need to be paid back. If demand drops for the products you’re selling, it could become challenging to pay back a creditor. Knowing your current ratio can keep you out of trouble.
2. Quick Ratio
Using a quick ratio lets you know if your business can meet financial obligations, mainly if an unexpected event occurs. For example, if you own a business selling flowers, can you afford to handle the cost of fixing a delivery truck if it breaks down? Using the quick ratio can help answer this question as seen below:
Quick Ratio = (Current Assets – Current Inventory) / Current Liabilities
Taking the same numbers from the first example, you currently have $500 cash, $1000 in checking and $10,500 in your inventory. This gives you total current assets equaling $20,000. With a line of credit of $10,000, your quick ratio would be 0.95 as indicated below:
($20,000 – $10,500)/$10,000 = 0.95
A healthy quick ratio is typically 1.0 or higher. With a quick ratio for your business equaling 0.95, it’s close to 1.0, indicating your business is healthy.
3. Return on Investment (ROI)
The ROI of your business shows the profitability you receive from investing in inventory. The ROI ratio is determined by using the following formula:
(Earnings – Cost of Investment)/Cost of Investment
If the earnings you make in your flower shop equal $20,000 and it cost you $10,500 to stock your business with fresh flowers, your ROI would be 0.9 as shown below:
($20,000 – $10,500)/$10,500 = 0.9
Having a high ROI ratio in your business is good. It shows you are doing well financially. Making a lot more money from selling your inventory than it costs allows you to keep the profits. You can use profits as you’d like when making a healthy amount. If it only cost you $5000 to stock your business with flowers and you sold them for $20,000, your ROI would be 4.0 as shown below:
($20,000 – $5000)/$5000 = 4
This example shows how lowering the cost of your inventory and selling it for more creates a higher ROI. Having a high ROI means you’re making a good amount of profits.
How To Evaluate the Financial Performance of Your Company
Using your financial statements regularly to determine business finance ratios is essential. Doing so can help you analyze your strengths and weaknesses. Taking specific categories, such as assets, inventory and your line of credit, and plugging them into formulas can provide you with information on the current health of your business.
Locating Weaknesses Using Business Finance Ratios for a Small Business
Using business financial ratios can provide you with critical information. While it may seem like your business is doing well, the underlying numbers may tell a different story. Once you determine them, you’ll know if your business is currently healthy. If you find weaknesses with your business financial ratios, you’ll know where to focus.
Judging Business Efficiency
Examining your business finance ratios can also help judge business efficiency. Using them can tell you how your business is performing. If they become more healthy, you are doing the right thing with your business. If they are getting worse, making changes may be necessary. Otherwise, you could start to have financial problems.
Making Plans After Assessing the Health of Your Company
After assessing your company’s health, it’s best to make plans. Doing so will help ensure your financial performance stays positive. Comparing past ratios with present numbers can be highly beneficial. Using business finance ratios is best when making business decisions. If you’re running your own company, do you have accurate business finance ratios?
If you want a clear picture of the financial position for your company, using business finance ratios is best. You can determine them by using your company’s financial statements. Knowing these numbers is essential. Creditors will use these ratios to see if you are a credit risk. Having a healthy ROI shows you are using inventory wisely. Doing so can make your business a lower credit risk and help ensure a creditor can trust you. They are more likely to lend you money when you have healthy ratios.
Using the Most Important Financial Ratios To Analyze Your Company
Using the quick ratio, current ratio and ROI can be beneficial. Other important financial ratios can be helpful as well. Talking to an accountant or researching the internet can be beneficial if you want to learn more. Applying more ratios to your business can give you even more insight into its health.
Also Read about Personal Finance: 6 Effective Ways for a Sound Debt Management