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Financial ratios offer entrepreneurs a way to evaluate their company’s performance and compare it other similar businesses in their industry.
Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This allows you to follow your company’s performance over time and uncover signs of trouble.
Here are some key financial ratios to measure the financial health of your business.
Measures how much debt a business is carrying as compared to the amount invested by its owners. This indicator is closely watched by bankers as a measure of a business’s capacity to repay its debts. Shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness. Indicates whether a business has sufficient cash flow to meet short-term obligations, take advantage of opportunities and attract favourable credit terms. A ratio of 1 or greater is considered acceptable for most businesses. Indicates a company's ability to pay immediate creditor demands, using its most liquid assets. 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. 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. 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.
Measures a business's capacity to generate adequate income to repay interest on its debt.
4. Return on total assets = Income from operations / Average total assetsMeasures the efficiency of assets in generating profit.
A higher turnover rate generally indicates less money is tied up in accounts receivable because customers are paying quickly.
2. Average collection period = Days in the period X Average accounts receivable / Total amount of net credit sales in periodIndicates the amount of time customers are taking to pay their bills.
3. Average days payable = Days in the period X Average accounts payable / Total amount of purchases on creditMeasures the average number of days it you are taking to pay suppliers.
4. Inventory turnover = Cost of goods sold / Average inventoryMeasures the efficiency of assets in generating profit.
Try BDC’s free financial ratio calculators to assess the performance of your business.
Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively in the current period or in the short-term. Although there are several efficiency ratios, they are similar in that they measure the time it takes to generate cash or income from a client or by liquidating inventory.
Efficiency ratios include the inventory turnover ratio, asset turnover ratio, and receivables turnover ratio. These ratios measure how efficiently a company uses its assets to generate revenues and its ability to manage those assets. With any financial ratio, it's best to compare a company's ratio to its competitors in the same industry.
Read on to find out more about these three efficiency ratios and why they matter.
- Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively.
- The inventory turnover ratio is used to determine if sales are enough to turn or use the inventory.
- A high asset turnover ratio means the company uses its assets efficiently, while a low ratio means its assets are being used inefficiently.
- The receivables turnover ratio measures a company's efficiency to collect debts and extend credit.
The inventory turnover ratio measures a company's ability to manage its inventory efficiently and provides insight into the sales of a company. The ratio measures how many times the total average inventory has been sold over the course of a period. Analysts use the ratio to determine if there are enough sales being generated to turn or utilize the inventory. The ratio also shows how well inventory is being managed including whether too much or not enough inventory is being bought.
The ratio is calculated by dividing the cost of goods sold by the average inventory.
For example, suppose Company A sold computers and reported the cost of goods sold (COGS) at $5 million. The average inventory of Company A is $20 million. The inventory turnover ratio for the company is 0.25 ($5 million/$20 million). This indicates that Company A is not managing its inventory properly because it only sold a quarter of its inventory for the year.
An efficiency ratio can also track and analyze commercial and investment bank performance.
The asset turnover ratio measures a company's ability to efficiently generate revenues from its assets. In other words, the asset turnover ratio calculates sales as a percentage of the company's assets. The ratio is effective in showing how many sales are generated from each dollar of assets a company owns.
The asset turnover ratio is calculated on an annual basis.
A higher asset turnover ratio means the company's management is using its assets more efficiently, while a lower ratio means the company's management isn’t using its assets efficiently.
The ratio is calculated by dividing a company's revenues by its total assets. For example, suppose a company has total assets of $1,000,000 and sales or revenue of $300,000 for the period. The asset turnover ratio would equal 0.30, ($300,000/$1,000,000). In other words, the company generated 30 cents for every dollar in assets.
The receivables turnover ratio measures how efficiently a company can actively collect its debts and extend its credits. The ratio is calculated by dividing a company's net credit sales by its average accounts receivable.
For example, a company has an average accounts receivables of $100,000, which is the result after averaging the beginning balance and ending balance of the accounts receivable balance for the period. The sales for the period were $300,000, so the receivable turnover ratio would equal 3, meaning the company collected its receivables three times for that period.
Typically, a company with a higher accounts receivables turnover ratio relative to its peers is favorable. A higher receivables turnover ratio indicates the company is more efficient than its competitors when collecting accounts receivable.