The difficulty of understanding massive amounts of financial data to lead your organization toward success challenges the decision-makers of businesses. When you understand and use critical funding ratios, it’s much easier to make tactical decisions. This can lead to valuable information being drawn from that confusion. Maintaining financial ratios can help you assess the state of your organization’s finances and inform more informed business decisions under this scenario.
Knowing the fundamentals of financial ratio analysis, and financial reporting may greatly simplify your business processes and financial strategy. This is something that we, as an integrated finance management platform, are trying to provide.
This blog will, therefore, guide you to the best 5 financial ratios that are key for all businesses. By highlighting the financial ratio formula, the blog will help you learn how to use these ratios.
What is a Financial Ratio?
Financial ratios are simple mathematical calculations made with quantitative information from a business’s financial records. They are employed to gather crucial data and insights regarding the operation, financial stability, and profitability of the business.
Financial ratios are crucial for entrepreneurs because they allow them to assess a company’s financial health above financial statements by comparing it to other companies in the same industry.
Although your cash flow, income, and balance sheets are helpful, they provide very little information. Beyond just the figures, financial ratios show how well your business can support itself, turn a profit, expand through sales, and control costs. They can also serve as an indicator that something isn’t functioning well, alerting managers and owners of companies to the need for change.
So, let’s move on to the best 5 financial ratios that businesses can use to improve their performance, along with the financial ratio formula required to calculate each financial ratio.
5 Financial Ratios For Business Owners
1. Return on Assets
By assessing net income to total assets, return on assets (ROA) calculates the business’s economic viability. Additionally, you can use it to pinpoint areas of your company where you can increase productivity and generate more revenue.
While a lower ROA can imply that a business is not making the most use of its assets, a higher ROA shows that a company is making more money for every dollar of assets.
A ratio of less than 5% can suggest that the business is having trouble turning a profit, whereas a ratio of 5% or above is typically seen as vital.
Consider a company with $400,000 in total assets and $40,000 in net income. The ROA is calculated as ($400,000$400,000) = 10%, which implies that the business is making a significant profit relative to its assets.
2. Working Capital Ratio/Current Ratio
The working capital ratio, also known as the current ratio, assesses a business’s short-term economic condition. This ratio compares a business’s current debts, which include accounts payable and temporary debt, to its current assets, like cash, accounts receivable, and inventory.
A higher working capital or current ratio demonstrates a business’s capacity to pay off short-term loans. On the other hand, a lower ratio may indicate an economic crisis.
For example, consider a company with current assets of $60,000 and $30,000 in current liabilities. Then, its current ratio will be a division of the former by the latter ($60,000\$30,000) = 2.
This indicates that the company has a higher current ratio, implying that it has a solid potential to pay off its short-term liabilities.
For a small business owner, the current ratio helps in analyzing the company’s financial viability and making more informed decisions for better business development.
3. Gross Margin Ratio
The gross margin ratio calculates a business’s financial success by dividing its net profit by its total revenue.
A greater gross margin ratio means that a business is making more money for every dollar of business. In contrast, a lower ratio can tell that the company is having trouble keeping expenditures under control.
For instance, consider a small business having a gross margin of $ 400,000 and a total revenue of $80,000. Then the gross margin calculated is ($ 400,000 \ $80,000) = 50%. This implies that the company is making a higher and stranger profit compared to its sales.
4. Debt to Equity Ratio
By calculating the entire amount of debt to the total amount of equity in an organization, the debt-to-equity ratio calculates the leverage it has financially.
A business’s likelihood of failure may grow if its debt-to-equity ratio is higher, which suggests that it is financing its activities with more borrowed funds. Conversely, a lower percentage can indicate better financial standing.
Generally speaking, most businesses consider a ratio of 2 or 2.5 to be good. This indicates that, for every $1 invested by shareholders in the industry, debt accounts for approximately 66%, with equity accounting for the remaining 33%.
For instance, let’s take a company with a total debt of $200,000 and a total equity of $300,000. The debt-to-equity ratio will be ($200,000\$300,000) = 0.8. This implies that the company has borrowed less money for its business operations.
5. Quick Ratio (Acid-test Ratio)
The quick ratio, also known as the acid-test ratio, assesses a company’s ability to pay short-term obligations using its more liquid assets, such as cash and its equivalents or accounts receivable. Inventories are not included in the current asset ratio. Entrepreneurs can perform a simple ratio analysis to determine whether their company can pay its bills and meet its expenses.
The industry average is regarded as a quick ratio of 1. When an organization’s quick ratio falls below 1, it may indicate that it lacks the liquid assets necessary to fulfill its current liabilities.
For example, a company has current assets of $50,000 with inventories of $30,000. They have current liabilities of $20,000. Now, the quick ratio is calculated as ($50,000 – $30,000)\ $20,000 = 1. This implies that they have the liquid assets necessary to fulfill its current liabilities.
Final Thoughts
After looking over the five key financial ratios, it is evident that these ratios are more than just figures. They are rather crucial instruments that offer a comprehensive view of the economic well-being of your company.
Nevertheless, proficient comprehension and utilization of these financial ratios necessitate not just expertise but also appropriate resources. This is where Paci.ai comes in. Paci.ai makes financial ratio analysis more accessible by combining cutting-edge AI technology with our team of highly skilled accounting professionals.
Our platform is made to make it easy for you to incorporate these understandings into your regular organizational activities. This helps you concentrate on making strategic decisions and expanding your company.
So, why wait?
Connect with us right now to gain more knowledge on financial management and learn to effectively use these financial ratios for financial analysis and reporting.
