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Every entrepreneur looks at the financial structure of their business. One way to quickly understand the financial health of your organization is to look at the various financial ratios. Financial ratios provide insight into cash, credit and inventory situation. They reveal the stability and health of your business. Businessmen must review these ratios to understand the changing trends in the company.
There are four basic types of ratios. They are:
These ratios measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts.
Current ratio also called working capital ratio is used to measure your company’s ability to generate cash to meet your short-term financial commitments. Quick ratio measures your ability to access cash quickly to support immediate demands. A ratio of 1.0 or greater is generally acceptable. But this ratio depends on your industry. A low ratio means your company might have difficulties meeting obligations or taking advantage of opportunities. Higher ratio means it’s time for you to invest more of your capital in projects.
These ratios are measured over a longer period of time and provide additional insight into different aspects of the business.
Inventory turnover looks at how long it takes for inventory to be sold and traded during the year. This ratio will help you in understanding where you can improve in inventory management.
Inventory to net working capital ratio can determine if you have too much of your working capital tied up in inventory. It is better if this ratio is lower. Evaluating inventory ratios depends on your industry and the type of business.
Average collection period looks at the average number of days customers take to pay for your products or services. You can improve this ratio by establishing clear cut credit policies and also providing incentives to encourage payment.
These ratios help in understanding the financial viability of your business. You can also gauge what your position is in the industry.
Net profit margin measures how much a company earns relative to its sales. Companies with higher profit margin are generally flexible and efficient.
Operating profit margin or coverage ratio measures earnings before interest and taxes. Through this you can assess your ability to expand your business through additional debt or other investments.
Return on assets (ROA) ratio tells how well management is utilizing the company’s various resources. Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. Profitability ratios are also compared with several companies from the same industry to know where you stand.
These ratios provide an indication of the long-term solvency of a company and extend of your use of long term debt to support your business.
Debt-to-equity and debt-to-asset ratios are used to see how your assets are financed. It can be financed from creditors or own investment.
The ratios mentioned above will help you determine your financial position. Closely examine other factors and data to fully understand your business performance.