Some business owners and managers dislike the financial analysis and management of their firms. But should they be blamed? Financial management isn’t as fun as developing an eCommerce website or advertising. But one is for sure; financial analysis or management isn’t fun, but it is absolutely necessary.
So, suck it up and learn it. You must get an in-depth look at your organization’s financial health and structure. One of the effective ways to analyze your company’s performance is by checking the critical financial ratios. Additionally, your business’s balance sheet can offer a portrait of the business’s assets (what it owns) and liabilities (what it owes). Here are the financial ratios that can help you assess your business performance.
1. Liquidity Ratios
These are financial ratios that determine the level of liquidity that your business has to cover current debts. These ratios also offer an overview of your company’s financial health. Some of the essential liquidity ratios include;
Current ratio
This financial ratio determines a company’s ability to make cash to meet its short-term financial obligations. It’s also known as the working capital ratio. It’s determined by dividing the number of current assets by your current liabilities.
Quick ratio
To calculate this ratio, divide the number of your current assets (less the inventory) by the number of current liabilities (less the current fraction of long-term debt). If the ratio is 1 or more, that’s acceptable. A lower ratio means your business will have challenges meeting financial obligations and might not be in a position to take advantage of growth opportunities that need quick cash.
Paying off your debts can improve the quick ratio, also known as the acid test. It is also recommended to wait for some time before making a long-term purchase. Another way of increasing your acid test ratio is by getting a long-term loan to finance your short-term debts. Review your credit policies with your customers and make the necessary adjustments to ensure you collect receivables on time.
A higher acid test ratio means that your capital isn’t fully utilized. So, consider investing your underutilized capital in various projects that drive business growth. Some of these projects include product development, marketing, innovation, and more. Remember, the investment project you choose will depend on the available capital, the nature of the industry, and more.
2. Efficiency ratio
These ratios are often measured over a 3-5 years period. Efficiency ratios offer more insights into various areas of your company, such as cash flow, collections, operational results, and more. Here are the efficiency ratios that you should know.
Inventory turnover
This type of ratio analyzes how long it will take to get your current inventory sold and replaced. To calculate inventory turnover, divide the total amount of purchases by the average amount of inventory in a particular period. The long your business inventory sits on your shelves, the higher the costs.
Your business earns gross profit whenever inventory turnover occurs. Inventory ratio enables you to know the areas you need to improve in terms of purchases and inventory management. For instance, you can analyze your purchasing habits and your customers to determine various ways to ensure your inventory is sold and replaced frequently.
Average collection period
This ratio analyzes the average number of days clients take to pay for goods and services. To get this ratio, divide the amount of receivables by the amount of sales, and multiply by 365. You may want to establish a clear credit policy and implement collection procedures. This can help you collect payments quickly.
3. Profitability Ratios
Profitability ratios evaluate the financial viability of a company. They compare the company’s profitability and performance to its peers in the same industry. It’s also possible to spot trends in your business by comparing various ratios over a specific period. Here are the essential profitability ratios.
Net profit margin
This ratio measures the business income (after tax) relative to the amount of sales. An organization with a higher net profit margin than its peers is considered more efficient, flexible, and in a position to take on opportunities.
Operating profit margin
This is also referred to as the coverage ratio. It measures income before tax and interests. The resulting amount is different from the net profit margin because of the impact of tax and interest expenses. Analyzing your company’s operating profit margin assesses your ability to expand your company through investments or additional debt.
Other important ratios that you must analyze include Return On Asset (how well your business is utilizing assets), Return On Equity (how well your company is performing in relation to shareholder’s investments), and cross-sectional analysis. The latter compares the ratios of different businesses from the same industry.
Beyond the numbers, check for patterns to establish your business financial performance over a specific period. Also, pay attention to other performance indicators.
