Financial Ratios are mathematical comparisons of financial statement account balances or categories. Most of these ratios result from dividing one account balance or financial measurement by another. If you recall, back in elementary school arithmetic you studied fractions. That's what ratios are. These relationships between the financial statement accounts serve as indicators and help internal company management, owners, and creditors understand how well a business is performing and what areas need improvement. Analyzing ratios and using vertical and horizontal analysis ( discussed earlier) make up what is called financial statement analysis.
How are ratios presented mathematically ?
- As a Percentage - 50%
- As a Decimal Number - 1.54
- Related to 1 - as 2:1
How often should these ratios and analyses be calculated ?
These ratios may be calculated on an annual, quarterly, or monthly basis. Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company. if you wait till the end of your year, you've let the barn door open. Doing monthy analyses provides current information so you can identify and correct problems before it's too late. When comparing these ratios, you should compare apples to apples. In other words, compare months to months, quarters to quarters, and years to years.
How many ratios are there ?
While ther are many ratios that could be calculated, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements may be needed.
In general, financial ratios can be broken down into four main categories with several specific ratio calculations within each category.
- Profitability Ratios
- Liquidity Ratios
- Solvency Ratios
- Activity/ Efficiency Ratios
Our explanation will involve the following 18 common financial ratios:
- Return on Total Assets Ratio
- Return on Fixed Assets Ratio
- Return on Equity Ratio
- Gross Margin Percentage Ratio
- Net Profit Margin Ratio
- Cash Ratio
- Working Capital Ratio
- Current Ratio
- Quick (acid test) Ratio
- Times Interest Earned
- Debt to Assets Ratio (Debt Ratio)
- Debt to Equity Ratio
- Accounts Receivable Turnover Ratio
- Average Accounts Receivable Collection Days Ratio
- Inventory Turnover Ratio
- Average Days of Inventory Ratio
- Accounts Payables Turnover Ratio
- Average Accounts Payable Days Ratio
How do you use them ?
As indicators to help internal company management, owners, and creditors understand how well a business is performing and what areas need improvement.
Financial ratios allow you to be able to make the following comparisons:
- Industry Averages
- Your own ratios from current and prior years
- Your planned ratios for the current and future years
Limitations of Financial Ratios
Since all of the information used in ratio analysis is derived from actual past results, these figures may not be representative of a business's future performance.
Small business owners should familiarize themselves with ratios and how they're used as a tracking device for anticipating changes in operations. Ratio analysis, when performed regularly over time, help small businesses recognize and adapt to trends affecting their operations.
Let's continue by discussing Profitablity Ratios